THE FACTOR APPROACH TO DERIVATIVE PRICING

The BIGPicture in a LITTLE Book
James A. Primbs
September 17, 2010
2
Contents
1 Basic Building Blocks and Stochastic Differential Equation Models 1
1.1 Brownian Motion and Poisson Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.1 Gaussian Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.2 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.3 Poisson Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.4 Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.5 Increments of Brownian Motion and Poisson Processes . . . . . . . . . . . . . . . . . . 3
1.2 Stochastic Differential Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.1 Differentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.2 The Differential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.3 Compound Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2.4 Ito Stochastic differential equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2.5 Poisson Driven Differential Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2 Ito’s Lemma 11
2.1 Ito’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1.1 The chain rule of ordinary calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1.2 Ito’s lemma for Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.1.3 Replacing dz
2
by dt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.1.4 Discussion of Ito’s lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.2 Ito’s lemma for Poisson Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.2.1 Interpretation of Ito’s lemma for Poisson . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.3 More versions of Ito’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.3.1 Ito’s Lemma for Compound Poisson Processes . . . . . . . . . . . . . . . . . . . . . . . 16
2.3.2 Ito’s Lemma for Brownian and Compound Poisson Processes . . . . . . . . . . . . . . 16
2.3.3 Ito’s Lemma for vector processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.4 Ito’s lemma, the product rule, and a rectangle . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.6 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3 Standard Stochastic Differential Equations with Solutions 21
3.1 Geometric Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.1.1 Stock Price Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.2 Geometric Poisson Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.2.1 A conditional lognormal version of geometric Poisson Motion . . . . . . . . . . . . . . 23
3.3 A jump-diffusion model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.4 A more general SDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.4.1 The Ornstein-Uhlenbeck Process and Mean Reversion . . . . . . . . . . . . . . . . . . 24
i
ii CONTENTS
3.5 Cox-Ingersoll-Ross Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
4 The Factor Approach to Arbitrage Pricing 29
4.1 The Factor Approach to Arbitrage Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.2 Returns and Factors Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.2.1 Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.2.2 Stochastic differential equations and factor models . . . . . . . . . . . . . . . . . . . . 30
4.3 The Factor Approach to Arbitrage using Returns . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.3.1 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.3.2 Null and Range Space Relationship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.3.3 A Useful Absence of Arbitrage Condition . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.3.4 Interpretations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
4.3.5 A Problem with Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.4 The Factor Approach using Price Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.4.1 Price Changes and Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.4.2 Profit/Loss and Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.5 Two standard examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.5.1 Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.5.2 Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
4.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
4.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
5 Constructing a Factor Pricing Framework 41
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.2 A Classification of Quantities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.2.1 Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.2.2 Underlying Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.2.3 Tradables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.2.4 A Derivative is a Tradable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.3 Factor Models for Underlying Variables and Tradables . . . . . . . . . . . . . . . . . . . . . . 43
5.3.1 Direct Factor Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.3.2 Factor Models via Ito’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.4 Tradables tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
5.5 Applying the Price APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
5.5.1 Relative Pricing and Marketed Tradables . . . . . . . . . . . . . . . . . . . . . . . . . 44
5.5.2 Pricing the Derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5.5.3 Underdetermined and Overdetermined Systems . . . . . . . . . . . . . . . . . . . . . . 45
5.6 Three Step Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
5.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
5.8 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
6 Application of the Factor Form: Equity Derivatives 49
6.1 Examples from Equity Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
6.1.1 Black-Scholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
6.1.2 Dividend Paying Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
6.1.3 Cash Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
6.1.4 Poisson Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
6.1.5 Options on Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
6.1.6 Jump diffusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
6.1.7 Exchange one asset for another . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
CONTENTS iii
6.1.8 Stochastic volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
6.2 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
7 Application of the Factor Form:
Interest Rate and Credit Derivatives 63
7.1 Notation and the Money Market Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
7.2 Interest Rate Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
7.2.1 Single Factor Short Rate Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
7.2.2 Multi-Factor Short Rate Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
7.2.3 Heath-Jarrow-Morton . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
7.2.4 The LIBOR Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
7.3 Credit Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
7.3.1 Defaultable Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
7.3.2 Defaultable Bonds with Random Intensity of Default . . . . . . . . . . . . . . . . . . . 73
7.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
8 Hedging 77
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
8.2 Hedging from a Factor Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
8.2.1 Description Using a Tradables Table . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
8.2.2 The Relationship Between Hedging and Arbitrage . . . . . . . . . . . . . . . . . . . . 78
8.2.3 Hedging Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
8.2.4 Hedging under Incompleteness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
8.2.5 A Question of Consistency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
8.3 Hedging from an Underlying Variable Sensitivity Perspective . . . . . . . . . . . . . . . . . . 83
8.3.1 Black-Scholes Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
8.3.2 Hedging Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
8.3.3 Derivatives imply Small Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
8.4 Higher Order Approximations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
8.4.1 The Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
8.4.2 A Delta-Gamma Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
8.4.3 Determining what the error looks like . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
8.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
8.6 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
9 The Road to Risk Neutrality 89
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
9.2 Do the Factors Matter? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
9.2.1 Brownian Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
9.2.2 Poisson Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
9.3 Risk Neutral Representations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
9.3.1 Brownian Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
9.3.2 Poisson Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
9.4 Pricing as an Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
9.5 Applications of Risk Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
9.5.1 How to Apply Risk Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
9.5.2 Black-Scholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
9.5.3 Poisson Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
9.5.4 HJM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
9.5.5 Libor Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
9.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
9.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
iv CONTENTS
Notation
• R - the real line (−∞, ∞).
• R
+
- the nonegative real line [0, ∞).
• S(t)- Stock price at time t.
• S
t
-
∂S
∂t
Partial derivative of S with respect to t.
• S
x
-
∂S
∂x
Partial derivative of S with respect to x.
• S
xx
-

2
S
∂x
2
Second partial derivative of S with respect to t.
• z(t) - Brownian motion.
• π(t; λ) - Poisson Process with intensity λ.
• x
T
- the transpose of a vector x.
• A
T
- the transpose of a matrix A.
• B
0
(t) - the time t value of the money market account.
• B(t|T) - time t price of a zero coupon bond with maturity T and face value $1 at time t
• B(t|T
1
; T
2
) - time t forward price of a zero coupon bond with maturity T
2
and face value $1 when
delivery of the forward contract is at time T
1
.
• r - a vector of returns.
• r
0
- a constant risk free rate of interest (when allowed to be a function of time, see the short rate
process below).
• r
0
(t) - the instantaneous short rate process at time t.
• r(t|s) - the instantaneous forward rate at time t between times s and s +ds.
• R(t|T) - spot rate for time T −t at the current time t.
• R(t|T
1
; T
2
) - forward interest rate between time T
1
and T
2
at time t.
• F(t|T) - time t forward price for contract with delivery at time T.
• f(t|T) - time t futures price for contract with delivery at time T.
• S(t|{T
i
}) - time t swap rate for swap dates {T
i
}.
• x(t−) - limit from the left: x(t−) = lim
h↑t
x(h).
• x

- notation for limit from the left: x(t−).
• λ - market price of risk.
v
vi CONTENTS
Chapter 1
Basic Building Blocks and Stochastic
Differential Equation Models
This chapter contains an introduction to the basic mathematics required for derivative pricing and financial
engineering. We provide building blocks for modeling assets in the form of Brownian motion and Poisson
processes. With these two building blocks we create more complicated models by using Brownian motion and
Poisson processes to drive differential equations (which are then known as stochastic differential equations).
The presentation here is tutorial and heuristic. However, don’t let that fool you. If you gain intuition from
it, then you have received a powerful tool to add to your toolbox for problem solving.
1.1 Brownian Motion and Poisson Processes
Brownian motion and Poisson processes are our fundamental building blocks for creating models of asset
prices. The key features are that Brownian motion has continuous sample paths (with probability 1), and
Poisson processes jump! We begin with Brownian motion which is built on the Gaussian random variable.
1.1.1 Gaussian Random Variables
An n-dimensional Gaussian (Normal) random variable is a random variable with density function:
X ∼ f
X
(x) =
1
(2π)
n/2
|Σ|
1/2
exp


1
2
(x −µ)
T
Σ
−1
(x −µ)

(1.1)
where µ ∈ R
n
is the mean and Σ ∈ R
n×n
is the covariance matrix:
µ = E[X], (1.2)
Σ = E[(X −µ)(X −µ)
T
]. (1.3)
1.1.2 Brownian Motion
Brownian motion (also known as a Wiener Processes) is a stochastic process built upon the Gaussian random
variable as follows. A real-valued stochastic process z(t) : t ∈ R
+
is a Brownian Motion if:
1. z(0) = 0.
2. z(t) −z(s) ∼ N(0, t −s) for t > s.
3. z(t
2
) −z(t
1
), z(t
3
) −z(t
2
), . . . , z(t
n
) −z(t
n−1
) are independent for t
1
≤ t
2
≤ · · · ≤ t
n
.
1
2CHAPTER 1. BASIC BUILDINGBLOCKS ANDSTOCHASTIC DIFFERENTIAL EQUATIONMODELS
You should remember the following facts about Brownian motion, as they make Brownian motion an ideal
building block for unpredictable but continuous asset price movements:
• There exists a version of Brownian motion that has continuous sample paths.
• Brownian motion is nowhere differentiable with probability 1.
The first property says that Brownian motion is appropriate for price processes that don’t jump. In many
cases, price processes do jump, hence we will need to introduce the Poisson process next to model jumps.
The second property can be interpreted in the context of predictability. If a curve is differentiable at a
point, then that means that locally it can be approximated by a line, with the slope of the line being the
derivative of the curve at that point. But this means that we can predict (to order dt) the future value of
the curve. In finance, we often want to assume that we cannot predict future prices. Non-differentiability
indicates that in the sense mentioned above, future prices are not predictable.
Therefore, Brownian motion is an ideal building block upon which to build asset price processes. A
sample path of Brownian motion is given in Figure 1.1.
0 0.2 0.4 0.6 0.8 1
−1
−0.8
−0.6
−0.4
−0.2
0
0.2
0.4
time
Sample Path of Brownian Motion
z
(
t
)
Figure 1.1: A typical sample path of Brownian motion.
Just as there are vector Gaussian random variables, we can define a vector Brownian motion as follows.
A vector Brownian motion z(t) ∈ R
n
with covariance structure Σ ∈ R
n×n
is a stochastic process satisfying
1. z(0) = 0.
2. z(t) −z(s) ∼ N(0, Σ(t −s)) for t > s.
3. z(t
2
) −z(t
1
), z(t
3
) −z(t
2
), . . . , z(t
n
) −z(t
n−1
) are independent for t
1
≤ t
2
≤ · · · ≤ t
n
.
Thus a vector Brownian motion is build upon the vector Gaussian random variable.
1.1. BROWNIAN MOTION AND POISSON PROCESSES 3
Brownian motion has continuous sample paths. That is too well behaved for some events we would like
to model. For instance, market crashes, bankruptcy, etc. are often discontinuous price movements. Hence,
we need a process that jumps! Poisson processes, which are built on the Poisson random variable, are what
we are looking for.
1.1.3 Poisson Random Variables
A discrete random variable X taking values in the whole numbers is Poisson with parameter λ > 0 if
P(X = k) =
λ
k
k!
exp(−λ) k = 0, 1, ... (1.4)
The mean of a Poisson random variable is E[X] = λ and the variance is V ar(X) = λ.
1.1.4 Poisson Process
A Poisson process is a stochastic process built on Poisson random variables as follows. A Poisson process
with parameter (intensity) λ is a stochastic process π(t; λ) : t ∈ R
+
that satisfies
1. π(0) = 0.
2. π(t) −π(s) is Poisson distributed with parameter λ(t −s) for t > s.
3. π(t
2
) −π(t
1
), π(t
3
) −π(t
2
), . . . , π(t
n
) −π(t
n−1
) are independent for t
1
≤ t
2
≤ · · · ≤ t
n
.
For us, the most important property of Poisson processes is that they jump! Hence, they are good models for
market crashes, jumps, bankruptcy, and other unexpected discontinuous price movements. A typical sample
path from a Poisson process with intensity λ = 1 is given in Figure 1.2.
The parameter λ is often called the intensity (or sometimes the propensity) of the Poisson process. You
can think of it as the expected number of jumps in a single time period. Alternatively, you expect to see a
single jump every
1
λ
time periods. Therefore, the larger the intensity, the more frequent the jumps.
We will assume that a Poisson process is continuous from the right, and not the left. That is, at the
exact time that a Poisson process jumps, it takes on the new value that it jumped to. Functions that are
right-continuous and have left-limits are called rcll functions (or cadlag or R-functions, etc). In a Poisson
process, it is important to remember that at a jump time it takes on the new value, thus making sample
paths of a Poisson process rcll functions.
1.1.5 Increments of Brownian Motion and Poisson Processes
Here are the intuitive pictures that I keep in mind when thinking of Brownian motion and Poisson Processes.
Over a small ∆t Brownian motion and Poisson Processes can be thought of in simple and intuitive ways.
We intuitively think of ∆t as a small increment in t. When dealing with a stochastic process X(t), we will
also think of ∆X(t) as the change the occurs in X over a small time period ∆t. That is
∆X(t) = X(t + ∆t) −X(t). (1.5)
This notion of an increment of a stochastic process will guide our intuition. In this way, we can look at
increments of Brownian motion and Poisson processes.
Brownian Motion
Over a small time ∆t, Brownian motion looks like
∆z(t) = z(t + ∆t) −z(t) ∼ N(0, ∆t) (1.6)
4CHAPTER 1. BASIC BUILDINGBLOCKS ANDSTOCHASTIC DIFFERENTIAL EQUATIONMODELS
0 1 2 3 4 5
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
time
π
(
t
)
Sample Path of a Poisson Processes with Intensity 1
Figure 1.2: A typical sample path of a Poisson process.
or, written slightly differently
∆z(t) = ǫ

∆t where ǫ ∼ N(0, 1) (1.7)
where this follows from the second defining property of Brownian motion. That is, a Brownian motion
differential looks like a standard Gaussian multiplied by

∆t. Thus, we will often use E[∆z] = 0 and
E[(∆z)
2
] = ∆t.
An even simpler picture arises from a binary approximation
∆z ≈

∆t w.p. 1/2


∆t w.p. 1/2
(1.8)
where w.p. stands for ”with probability”. This is depicted in figure 1.3.
Figure 1.3: Binary model of an increment in Brownian motion .
1.2. STOCHASTIC DIFFERENTIAL EQUATIONS 5
Poisson Process
A Poisson Process can also be approximated over a small time period ∆t. Over ∆t it is
∆π(t; λ) = π(t + ∆t; λ) −π(t; λ) = X where X ∼ Poisson(λ∆t). (1.9)
A binary approximation to a Poisson process is
∆π(λ) ≈

1 w.p. λ∆t
0 w.p. 1 −λ∆t
(1.10)
A simple picture of this heuristic increment model is given in Figure 1.4. Note that for a Poisson process,
Figure 1.4: Binary model of an increment of a Poisson process.
∆π is either 0 or 1 to order ∆t.
Thus, note the key difference between a Brownian motion and a Poisson process. From the simple binary
model approximations, we see that in a Brownian motion the size of the move scales with the square root of
∆t. Hence over short periods of time the move in a Brownian motion is also small. This is why Brownian
motion has continuous paths. On the other hand, in a Poisson process, from the binary model we see that
the move size can always be 1, regardless of how small ∆t is. On the other hand, the probability of having
a jump of size 1 scales with ∆t and is small if ∆t is small. Thus, Poisson processes jump when they move.
Over small periods of time the probability of a jump is also small. This is the essential difference between
Brownian motion and the Poisson process.
1.2 Stochastic Differential Equations
A simple way to think of a stochastic differential equation is as a differential equation that is driven by a
stochastic process. We will use this point of view here. Also, to avoid the technicalities of stochastic calculus,
we will present a simple intuitive approach to stochastic differential equations and stochastic differentials.
1.2.1 Differentials
Roughly speaking, the notion of a differential or infinitesimal of a process is the idea that in an increment
∆X(t) = X(t + ∆t) −X(t) (1.11)
we can take ∆t to be infinitesimally small. In such a case we would write
dX(t) = X(t +dt) −X(t) (1.12)
where dt is ”just a little bit of t”, to quote Gillespie [8]. However, (1.12) has a problem when it comes to
processes that jump that are assumed to be right continuous. The Poisson process is a good example.
6CHAPTER 1. BASIC BUILDINGBLOCKS ANDSTOCHASTIC DIFFERENTIAL EQUATIONMODELS
The Problem with Jumps
We have to be very careful when a process has jumps and we assume right continuity of paths. Here is the
problem. Assume that a Poisson process is currently at 0. That is π(t) = 0. Now, assume that a jump
occurs at time s. Our convention will be to assume that at the exact time of the jump, the Poisson process
jumps to 1. That is π(s) = 1. This means that for us, Poisson processes, and all other processes with jumps,
will be continuous from the right. Hence,
lim
h↓s
π(h) = π(s) (1.13)
A picture of this situation is shown in Figure 1.5.
Figure 1.5: A jump at time s.
Since this is our convention, now let’s consider defining the differential of a Poisson process as
dπ(t) = π(t +dt) −π(t) (1.14)
where dt > 0.
Now, we know that a jump occurred at time s, so intuitively we should have dπ(s) = 1. However, let us
take the limit of dπ(t) for any t (including s) as dt ↓ 0. We obtain
lim
dt↓0
dπ(t) = lim
dt↓0
π(t +dt) −π(t) = π(t) −π(t) = 0 (1.15)
where this calculation followed by right continuity as defined by equation (1.13). But this indicates that π
never jumps! Something must be wrong!!
What is wrong is that we have assumed that π is right continuous, and then when we add dt to the
current time, we are implicitly taking the limit from the right. Hence, we are guaranteed never to capture
the jump!
This is purely a problem that arises from our convention to assume that Poisson processes are right
continuous. If we had assumed left continuity, then we wouldn’t have any problem. However, it is common
in the literature to assume processes are right continuous, so we have adopted this convention. Therefore,
we need to adjust our notion of a differential of a stochastic process slightly to account for our convention.
1.2.2 The Differential
The solution to the above problem is that for a differential, we should think of the following
dX(t) = X(t +dt) −X(t−) (1.16)
where X(t−) = lim
h↑t
X(h) is the limit from the left of X at time t. By using the limit from the left, we
make sure to capture jumps of the process, no matter how small dt is made.
1.2. STOCHASTIC DIFFERENTIAL EQUATIONS 7
We will develop this point of view (which unfortunately can’t be made rigorous, but provides the proper
intuition). Hence, reviewing from above, with Brownian motion we would have:
dz(t) = z(t +dt) −z(t) ∼ N(0, dt). (1.17)
Note that since Brownian motion has continuous sample paths, z(t−) = z(t). However, for a Poisson process,
we should think of differentials as
dπ(t; λ) = π(t +dt; λ) −π(t−; λ) ∼ Poisson(λdt) (1.18)
in order to make sure that we capture jumps.
Don’t forget that we also have the binary model approximations of Figures 1.3 and 1.4. Those binary
models provide the proper intuition, and in both cases, sums of them will limit as Brownian motion or a
Poisson process. For the differential, we simply replace ∆t by dt in (1.8) and (1.10), giving
dz ≈

dt w.p. 1/2


dt w.p. 1/2
(1.19)
and
dπ(λ) ≈

1 w.p. λdt
0 w.p. 1 −λdt
. (1.20)
1.2.3 Compound Poisson Process
When Poisson processes jump, they jump up by 1. We can generalize this and allow them to jump randomly.
Let π(t; λ) be a Poisson process with jump times t
1
, t
2
, .... Construct a new process π
Y
(t; λ), by assigning
jump Y
1
at time t
1
, Y
2
at time t
2
, etc. where Y
1
, Y
2
, ... are iid random variables. This process can be
written as
π
Y
(t; λ) =
π(t;λ)
¸
i=0
Y
i
. (1.21)
That is, at time t it is the sum of π(t; λ) iid copies of Y , where π(t; λ) is a standard Poisson process. Processes
of this form can also conveniently be written as integrals,
π
Y
(t, λ) =
π(t;λ)
¸
i=0
Y
i
=

t
0
Y
s
dπ(s; λ). (1.22)
For this reason, we represent the differential form of a compound Poisson process by Y dπ(t, λ). That is, we
may write

Y
= Y dπ. (1.23)
Following along the lines of the binary approximation to a Poisson process as in Figure 1.4, an infinitesimal
model of a compound Poisson process can be thought of as
Y dπ(λ) ≈

Y
i
w.p. λdt
0 w.p. 1 −λdt
(1.24)
and a heuristic infinitesimal picture of this is given in Figure 1.6.
1.2.4 Ito Stochastic differential equations
Stochastic integrals can be defined in different ways. The most useful for us is the Ito stochastic integral. At
this point, I will not delve into the depths of the stochastic integral (because often people are never able to
return!), but merely provide the intuition that you should take away when considering stochastic differential
equations.
8CHAPTER 1. BASIC BUILDINGBLOCKS ANDSTOCHASTIC DIFFERENTIAL EQUATIONMODELS
Figure 1.6: Infinitesimal model of a compound Poisson process.
A stochastic differential equation will be written as:
dx(t) = a(x(t), t)dt +b(x(t), t)dz(t) (1.25)
where in this case, it is being driven by Brownian motion z(t). (At this stage, I will ignore the technical
conditions that must be placed on a and b in order to make such an equation well defined.) We will interpret
this equation as follows:
x(t +dt) −x(t) = a(x(t), t)dt +b(x(t), t)(z(t +dt) −z(t)). (1.26)
Since z(t) has independent increments, and a(x(t), t) and b(x(t), t) are evaluated at time t, they are inde-
pendent of dz(t) = z(t + dt) − z(t). This is important! It allows us to do the following simple calculations
of the instantaneous drift and variance.
Instantaneous Drift and Variance
We can interpret a(x(t), t) as related to the instantaneous drift and b(x(t), t) as related to the instantaneous
volatility as follows:
E[dx|x(t)] = E[a(x(t), t)dt +b(x(t), t)dz(t)|x(t)] (1.27)
= a(x(t), t)dt +b(x(t), t)E[dz(t)|x(t)] (1.28)
= a(x(t), t)dt. (1.29)
Therefore, a(x(t), t) determines the instantaneous drift. On the other hand, we can compute the instanta-
neous variance of x as follows
E[(dx −a(x(t), t)dt)
2
|x(t)] = E[b(x(t), t)
2
dz(t)
2
|x(t)] (1.30)
= b
2
(x(t), t)E[dz(t)
2
|x(t)] (1.31)
= b
2
(x(t), t)dt (1.32)
Hence, b
2
(x(t), t) determines the instantaneous variance of x.
1.2.5 Poisson Driven Differential Equations
We can also drive a differential equation by a Poisson process
dx(t) = a(x(t−), t)dt +b(x(t−), t)Y dπ(t; λ) (1.33)
where note that we have written x(t−) in the arguments of a and b. By x(t−) we mean x(t−) = lim
h↓0
x(t−h).
That is, x(t−) is the limit from the left at time t. We will assume that a and b are left continuous in the t
1.3. SUMMARY 9
argument so that we may use t instead of t− in the second argument of a and b. We will also sometimes use
the notation x

when we want to suppress the argument t, or even a

when suppressing the arguments of
a. The reason for using limits from the left is that in a Poisson process, we interpret our differential as
dπ(t) = π(t +dt) −π(t−)
and for the Ito integral, we assume that the coefficients a and b are evaluated at the point in time that the
differential starts from. This is t−.
This limit from the left is also important in a and b because we want a and b to be independent of dπ.
The only way we can do this is to make sure that we use left limits. Note that this means that if π(t) jumps
at time t, which also causes a jump in x at time t, we evaluate x(t−) in a and b which immediately preceeds
the jump.
With that established, once again, we can compute the instantaneous mean and variance:
E[dx(t)|x(t−)] = E[a(x(t−), t)dt +b(x(t−), t)Y dπ(t)|x(t−)] (1.34)
= a(x(t−), t)dt +b(x(t−), t)E[Y dπ(t)|x(t−)] (1.35)
= a(x(t−), t)dt +b(x(t−), t)E[Y ]λdt (1.36)
Hence, in this case, the dπ(t) term can contribute to the instantaneous mean. This can make things messy!
It is often nicer to think of the first term as the ”mean” term, and the second as the ”risk” term. To do
this, we would like the second term to have zero instantaneous mean. Hence, we will often ”compensate” the
Poisson process to give it zero mean. This is done by simply subtracting off the instantaneous mean from
the second term and adding it to the first.
dx(t) = (a(x(t−), t) +b(x(t−), t)E[Y ]λ)dt +b(x(t−), t)(Y dπ(t) −E[Y ]λdt) (1.37)
Then we can also compute the instantaneous variance:
E[(dx(t) −(a(x(t−), t) +b(x(t−), t)E[Y ]λ)dt)
2
|x(t−)]
= E[b
2
(x(t−), t)(Y dπ(t) −E[Y ]λdt)
2
|x(t−)]
= b
2
(x(t−), t)V ar(Y dπ(t))
= b
2
(x(t−), t)(E[Y
2
dπ(t)
2
) −E[Y ]
2
E[dπ(t)]
2
)
= b
2
(x(t−), t)(E[Y
2
]E[dπ(t)
2
] −E[Y ]
2
λ
2
dt
2
)
= b
2
(x(t−), t)(E[Y
2
](λdt +λ
2
dt
2
) −E[Y ]
2
λ
2
dt
2
)
= b
2
(x(t−), t)E[Y
2
]λdt +O(dt
2
)
Hence, to order dt, the instantaneous variance is given by b
2
(x(t−), t)E[Y
2
]λ.
1.3 Summary
Brownian motion (built upon the Gaussian random variable) and the Poisson Process (built upon the Poisson
random variable) are the basic building blocks used to create models of prices. In particular, we use these two
processes to drive differential equations and that will allow us to capture a wide range of price phenomena.
Due to the continuity of Brownian motion, it is good for modeling price paths and variables that do not
jump. On the other hand, Poisson processes are an essential building block for modeling jumps in price
processes or variables.
Much intuition can be gained from simple ”incremental” and ”differential” models of processes and
stochastic differential equations. The simple binary approximations to Brownian motion and Poisson pro-
cesses are enough to correctly guide your intuition in the vast majority of cases. Thus, for modeling purposes,
make sure you have a solid understanding of these two building block processes.
10CHAPTER 1. BASIC BUILDINGBLOCKS ANDSTOCHASTIC DIFFERENTIAL EQUATIONMODELS
1.4 Problems
Problem 1.4.1 Verify that our infinitesimal model of a Poisson process over small time dt:
dπ =

1 wp. λdt
0 wp. 1 −λdt
(1.38)
has a mean and variance that agree with a Poisson random variable with parameter λdt to order dt.
Problem 1.4.2 Poisson Processes
Consider the time interval [0, 1]. Chop this time interval into n parts of equal length. Over each interval
define the independent and identically distributed random variables X
i
where
X
i
=

1 w.p. λ/n
0 w.p. 1 −λ/n
(1.39)
Let
Y =
n
¸
i=1
X
i
(1.40)
(a) What is Pr(Y = 0)?
(b) In your answer in (a), take the limit as n → ∞. What do you get?
(b) What is Pr(Y = 1)?
(c) Again take the limit. What is your answer?
(d) Now consider an arbitrary but fixed k with k < n. What is Pr(Y = k).
(e) Again take the limit as n → ∞, and show that this converges to the Poisson random variable. (You
will probably want to use Stirling’s formula n! ∼

2πe
−n
n
n+
1
2
. This calculation is a bit tricky!)
(Note: In this problem we converge to a Poisson random variable with parameter λ since we took the time
interval to be 1. If the time interval is t, we will converge to a Poisson random variable with parameter λt.
As a function of t, we arrive at a Poisson process.)
Problem 1.4.3 Poisson Processes again.
Consider the following Markov chain. Let the state space be the whole numbers x = 0, 1, 2, .... Consider
the following transition probabilities over the time instant dt:
Pr(x(t +dt) = n|x(t) = n) = 1 −λdt (1.41)
Pr(x(t +dt) = n + 1|x(t) = n) = λdt (1.42)
Let p
n
(t) = Pr(x(t) = n).
(a) Write down a differential equation for p
0
(t). (hint: to derive a differential equation, consider the
amount of probability that flows into and out of the state x = 0 over time dt.)
(b) Assume p
0
(0) = 1 (that is, at time zero, x = 0 with probability 1). Solve the differential equation for
p
0
(t).
(c) Derive a differential equation for p
n
(t), n > 0. Given your answer in (a), solve for p
1
(t). Explain how
you could solve for p
n
(t) for any n.
(Note: again we have arrived at a Poisson process, but this time through Markov chain theory. A Poisson
process is an example of a continuous time Markov process, and the set of differential equations you derived
is the ”forward equation” for this process.)
Chapter 2
Ito’s Lemma
2.1 Ito’s Lemma
Ito’s lemma is the chain rule for stochastic calculus. In this chapter we present Ito’s lemma for Brownian
motion and Poisson processes. It has been said that all of math finance can be done with just the knowledge
of Ito’s lemma. To you, this means that you should make sure that you know (and understand) Ito’s lemma.
In what follows, we will present versions of Ito’s lemma for Brownian motion and Poisson processes.
2.1.1 The chain rule of ordinary calculus
In ordinary calculus, here is how the chain rule works in conjunction with a differential equation. Let x(t)
follow the differential equation
dx
dt
= a(x, t). (2.1)
Now consider a function of x(t) and t. Let’s call this function f(x(t), t). Assuming that f is differentiable,
we can ask what the derivative of f is. To calculate it, we simply apply the chain rule
df(x, t)
dt
=
∂f
∂x
dx
dt
+
∂f
∂t
= f
x
dx
dt
+f
t
(2.2)
where we are using the notation f
x
=
∂f
∂x
and f
t
=
∂f
∂t
. Finally, we can substitute in for
dx
dt
from (2.1), giving
df(x, t)
dt
=
∂f
∂x
a(x, t) +
∂f
∂t
= a(x, t)f
x
+f
t
. (2.3)
This is a fairly straightforward calculation. However, when dealing with stochastic differential equations,
the simple chain rule of ordinary calculus does not work. The reason is simple. Brownian motion is not
differentiable so we can’t really take its derivative or the derivative of any function of Brownian motion.
Also, Poisson processes jump, and at these jumps it is not even continuous, let alone differentiable. Thus,
for stochastic differential equations we need to develop the correct mathematics for dealing with a function
of a variable that follows a stochastic differential equation. The guiding result is known as Ito’s lemma.
Multivariables Taylor Series Expansions
Before diving into Ito’s lemma, you should make sure that you recall your multivariables Taylor series
expansions to second order. This is extremely important! Ito’s lemma for Brownian motion is basically just
a modified Taylor expansion to second order. So, let’s recall up to second order, the Taylor series expansion
11
12 CHAPTER 2. ITO’S LEMMA
of a function f(x, t) around a point (x
0
, t
0
),
f(x, t) = f(x
0
, t
0
) +f
t
(x
0
, t
0
)(t −t
0
) +f
x
(x
0
, t
0
)(x −x
0
) (2.4)
+
1
2
f
tt
(x
0
, t
0
)(t −t
0
)
2
+f
xt
(x
0
, t
0
)(x −x
0
)(t −t
0
) +
1
2
f
xx
(x
0
, t
0
)(x −x
0
)
2
+. . . (2.5)
Now, we will typically denote dx = x−x
0
, dt = t −t
0
, and df = f(x, t) −f(x
0
, t
0
), so that a Taylor series
expansion is
df = f
t
dt +f
x
dx +
1
2
f
tt
dt
2
+f
xt
dxdt +
1
2
f
xx
dx
2
+. . . (2.6)
and the arguments of f
t
, f
x
, ... have been supressed.
In the multivariable case when x ∈ R
n
, the Taylor series expansion is
df = f
t
dt +f
x
dx +
1
2
f
tt
dt
2
+dx
T
f
xt
dt +
1
2
dx
T
f
xx
dx +. . . (2.7)
where
f
x
= [f
x1
, . . . , f
xn
], f
xx
=

f
x1x1
. . . f
x1xn
.
.
.
.
.
.
.
.
.
f
xnx1
. . . f
xnxn
¸
¸
¸ (2.8)
A useful trick in the multivariable case is to note that
dx
T
f
xx
dx = Tr(dx
T
f
xx
dx) = Tr(f
xx
dxdx
T
) (2.9)
where Tr(·) is the Trace of a matrix (i.e. the sum of the diagonal elements).
Operationally, Ito’s lemma for Brownian motion boils down to nothing more than substituting dx =
adt +bdz in the Taylor expansion of (2.6) (or (2.7) in the multivariable case) for dx, interpreting terms such
as dz
2
, and then throwing away terms of order higher than dt.
If that sounds simple, then you are right. Let’s see how it works in more detail.
2.1.2 Ito’s lemma for Brownian motion
Given the differential of x(t), Ito’s lemma allows us to compute the differential of a function of x(t) and t.
Hence, it is the ”chain rule” for stochastic differential equations. The following result is Ito’s lemma when
x(t) is a process governed by a stochastic differential equation driven by Brownian motion.
(⋆) Ito’s Lemma for Brownian Motion:
Consider the stochastic differential equation (SDE)
dx = a(x, t)dt +b(x, t)dz (2.10)
and let f(x, t) be a twice continuously differentiable function of x and t. Then
df(x, t) = (f
t
+a(x, t)f
x
+
1
2
b
2
(x, t)f
xx
)dt +b(x, t)f
x
dz. (2.11)
”Heuristic Proof”: I will suppress the arguments of a and b for convenience. Consider writing the Taylor
expansion of df.
df = f(x(t +dt), t +dt) −f(x(t), t)
= f
t
dt +f
x
dx +
1
2
f
tt
(dt)
2
+
1
2
f
xx
(dx)
2
+f
xt
dxdt +...
2.1. ITO’S LEMMA 13
Next, we will substitute in for dx using dx = adt +bdz which gives
df = f
t
dt +f
x
(adt +bdz) +
1
2
f
tt
(dt)
2
+
1
2
f
xx
(adt +bdz)
2
+f
xt
(adt +bdz)dt +...
= f
t
dt +f
x
adt +f
x
bdz +
1
2
f
tt
(dt)
2
+
1
2
f
xx
(a
2
dt
2
+ 2abdtdz +b
2
dz
2
) +f
xt
(adt
2
+bdzdt) +...
Now we take a crucial step, and only keep terms up to order dt using the following logic. The standard
deviation of dz is of order

dt. Hence, we think of dz as being of order dt
1/2
and only keep terms up to
order dt yielding
df = f
t
dt +f
x
adt +f
x
bdz +
1
2
f
xx
b
2
dz
2
...
Finally we replace dz
2
by it’s expectation dt which leads to Ito’s lemma
df = (f
t
+af
x
+
1
2
b
2
f
xx
)dt +bf
x
dz. (2.12)
2.
In this ”derivation” there were a couple of dubious steps. The most glaring was replacing dz
2
by its expec-
tation dt. Let’s see why this was a reasonable thing to do ...
2.1.3 Replacing dz
2
by dt
Here is a simple argument as to why it is reasonable to replace dz
2
by dt.
If we can say that dz
2
= dt, then by integrating we would have

T
0
dz
2
=

T
0
dt = T. (2.13)
Hence, let us see if this makes sense. Let’s approximate the integral above by the sum
S(T, ∆t) =
T
∆t
−1
¸
i=0
(z((i + 1)∆t) −z(i∆t))
2

T
0
dz
2
. (2.14)
Now, the claim is that as ∆t → 0, then S(T, ∆t) → T. But note that S(T, ∆t) is a random variable since it
involves z(t). Therefore, we are trying to show that the random variable S(T, ∆t) converges to the constant
T. To do this, we will show that the mean of S(T, ∆t) is equal to T, and its variance approaches zero. This
does the trick, since a random variable with zero variance must be a constant equal to it’s mean. (When we
show that the variance approaches zero, we are proving convergence in mean square, or L
2
(P).)
Computing the mean:
Okay, let’s first compute the mean of S(T, ∆t):
E[S(T, ∆t)] = E

T
∆t
−1
¸
i=0
(z((i + 1)∆t) −z(i∆t))
2
¸
¸
=
T
∆t
−1
¸
i=0
E

(z((i + 1)∆t) −z(i∆t))
2

=
T
∆t
−1
¸
i=0
∆t = T.
(2.15)
Hence, the mean is T.
Computing the variance:
Now let’s compute the variance of S(T, ∆t). By independent increments
V ar(S(T), ∆t) = V ar

¸
T
∆t
−1
¸
i=0
(z((i + 1)∆t) −z(i∆t))
2
¸

=
T
∆t
−1
¸
i=0
V ar((z((i + 1)∆t) −z(i∆t))
2
). (2.16)
14 CHAPTER 2. ITO’S LEMMA
But since z((i + 1)∆t) −z(i∆t) is Gaussian with mean zero and variance ∆t, we have
V ar((z((i + 1)∆t) −z(i∆t))
2
) = E[(z((i + 1)∆t) −z(i∆t))
4
] −E[(z((i + 1)∆t) −z(i∆t))
2
]
2
= 3(∆t)
2
−(∆t)
2
= 2(∆t)
2
.
Therefore as ∆t → 0, we have
V ar(S(T, ∆t)) =
T
∆t
−1
¸
i=0
V ar((z((i + 1)∆t) −z(i∆t))
2
) =
T
∆t
−1
¸
i=0
2(∆t)
2
= 2T∆t → 0. (2.17)
Hence, the limit of the variance of S(T, ∆t) is zero. That means that the limit (in L
2
(P)) is a constant and
equal to the mean T. Note that the above argument has much of the flavor of the weak law of large numbers.
This is the essential argument that allows us to use dz
2
= dt and a simplified version of the argument behind
a real derivation of Ito’s lemma.
Let’s see an example of Ito’s lemma applied to so-called geometric Brownian motion.
Example 2.1.1 Let dx = axdt + bxdz and consider f(x) = ln(x). Then, according to Ito’s lemma, f(x)
satisfies
df = (f
t
+axf
x
+
1
2
b
2
x
2
f
xx
)dt +bxf
x
dz (2.18)
= (a −
1
2
b
2
)dt +bdz (2.19)
where we have used that f
t
= 0, f
x
=
1
x
, and f
xx
= −
1
x
2
.
2.1.4 Discussion of Ito’s lemma
At the risk of overdoing an attempt to provide intuition behind Ito’s lemma, I will leave you with the
following thoughts.
In Ito’s lemma, we kept terms up to order dt in the Taylor expansion. We are used to doing things like
this from ordinary calculus, but now that we are dealing with stochastic processes, we might question this
step. In particular, the standard deviation of dz is dt
1/2
. This means that moves in dz are usually much
larger than dt. Why doesn’t this dz term completely dominate and even allow us to ignore terms of order
dt?
Again, I appeal to the wisdom of Gillespie [8]. He gave the following explanation, which is based on the
story of the tortoise and the hare. As the story goes, the tortoise and the hare race each other. The tortoise
being slow, starts the race and steadily works his way toward the finish line. The hare, on the other hand,
is quick and jumpy. He is much faster than the hare, but runs forward and backwards and easily gets off
track. In the end of the story, the tortoise wins the race.
Now your asking, ”What does this have to do with Ito’s lemma and stochastic differential equations?”
Well, the deterministic dt drift term is like the tortoise. It marches forward at a constant dt rate. On the
other hand, the dz term is like the hare. It is quick, and jumps around like order dt
1/2
. But its direction
is random. Some of the time it jumps forward and other times, backwards. Together, both the dt and dz
terms contribute to the stochastic differential equation and neither term is guaranteed to dominate, just like
we don’t know whether the tortoise or the hare will win the race!
2.2 Ito’s lemma for Poisson Processes
Ito’s lemma for Brownian motion is more subtle that Ito’s lemma for Poisson Processes. (The key difference
is that Poisson processes have sample paths of finite variation, and this allows us to define the stochastic
integral pathwise. Hence, Ito’s lemma in this case is merely an application of the Lebesgue-Stieljies calculus.)
2.2. ITO’S LEMMA FOR POISSON PROCESSES 15
(⋆) Ito’s Lemma for Poisson Processes:
Given a Poisson stochastic differential equation (SDE)
dx = a(x

, t)dt +b(x

, t)dπ (2.20)
let f(x, t) be a continuously differentiable function of x and t. Then
df(x, t) = (f
t
+a(x

, t)f
x
)dt + (f(x

+b(x

, t), t) −f(x

, t))dπ. (2.21)
The real derivation of this is using Lebesgue-Stieljies calculus, but once again I will provide a nice heuristic
argument. This time when we consider the differential df we have to be careful because x
t
jumps! Taylor
expansions work well as an approximation when dx is small, however with jumps dx can be large! Note how
this plays into our derivation.
”Heuristic Proof”: We start by writing out the differential and substituting in for dx.
df = f(x(t +dt), t +dt) −f(x

, t) (2.22)
= f(x(t−) +a

dt +b

dπ, t +dt) −f(x

, t) (2.23)
where a

= a(x(t−), t) and b

= b(x(t−), t). Now, we note that possible jumps come from dπ. I don’t like
this term, so I will add and subtract a term that doesn’t contain the jump
df = f(x

+a

dt +b

dπ, t +dt) −f(x

+a

dt, t +dt) +f(x

+a

dt, t +dt) −f(x

, t) (2.24)
Now the final two terms don’t have a jump in them, so I will approximate them using ordinary calculus.
df = f(x

+a

dt +b

dπ, t +dt) −f(x

+a

dt, t +dt) + (f
t
+a

f
x
)dt +O(dt
2
) (2.25)
Now let’s analyze the first two terms
f(x

+a

dt +b

dπ, t +dt) −f(x

+a

dt, t +dt) (2.26)
When their is no jump in dπ, this term is zero. No jumps occur with probability 1 −λdt. When there is a
jump we have dπ = 1 and
f(x

+a

dt +b

, t +dt) −f(x

+a

dt, t +dt). (2.27)
This occurs with probability λdt. Since the a

dt term in the argument is of order dt, then overall, we can
think of the effect of the a

dt term as overall being of order dt
2
. Therefore, as dt → 0, to order dt overall
this term is replaced by
f(x

+a

dt +b

, t +dt) −f(x

+a

dt, t +dt) → f(x

+b

, t) −f(x

, t). (2.28)
Hence, combining the above arguments gives
f(x

+a

dt +b

dπ, t +dt) −f(x

+a

dt, t +dt) → (f(x

+b

, t) −f(x

, t))dπ (2.29)
which completes the derivation of Ito’s lemma. 2
2.2.1 Interpretation of Ito’s lemma for Poisson
Ito’s lemma for Poisson processes simply says that when the Poisson process doesn’t jump, use ordinary
calculus. When it jumps, the move in f is determined completely by the jump. That is it! Let’s see an
example of this.
16 CHAPTER 2. ITO’S LEMMA
Example 2.2.1 Let dx = axdt + (b − 1)xdπ and consider f(x) = ln(x). By Ito’s lemma for Poisson
processes, f(x) satisfies
df = (f
t
+f
x
ax)dt + (f(x

+ (b −1)x

) −f(x

))dπ (2.30)
= adt + (ln(bx

) −ln(x

))dπ (2.31)
= adt + ln(b)dπ (2.32)
where we have used that f
t
= 0 and f
x
=
1
x
.
2.3 More versions of Ito’s Lemma
In this section I will present other useful versions of Ito’s lemma. Heuristic derivations follow along the lines
of those for Brownian motion and the Poisson process. It is worthwhile working your way through a couple
of them, and through some of the problems at the end.
2.3.1 Ito’s Lemma for Compound Poisson Processes
When we are using a compound Poisson process, Ito’s lemma is modified slightly as follows.
(⋆) Ito’s Lemma for Compound Poisson Processes:
Given an SDE
dx = a(x

, t)dt +b(x

, t)Y dπ (2.33)
Let f(x, t) be a continuously differentiable function of x and t. Then
df(x, t) = (f
t
+a

f
x
)dt + (f(x

+Y b

, t) −f(x

, t))dπ (2.34)
This version of Ito’s lemma can be derived in a manner similar to Ito’s lemma for Poisson processes.
2.3.2 Ito’s Lemma for Brownian and Compound Poisson Processes
If we combine Brownian motion and compound Poisson processes, then we have the following result.
(⋆) Ito’s for Brownian and Poisson
Given a Poisson stochastic differential equation (SDE)
dx = a(x

, t)dt +b(x

, t)dz +Y dπ (2.35)
let f(x, t) be a twice continuously differentiable function of x and t. Then
df(x, t) = (f
t
+a(x

, t)f
x
+
1
2
b(x

, t)
2
f
xx
)dt +b(x

, t)f
x
dz + (f(x

+Y, t) −f(x

, t))dπ (2.36)
Again, this can be shown with arguments similar to those given above.
2.3.3 Ito’s Lemma for vector processes
If we have multiple Brownian motions, then we have the following results
(⋆) Ito’s for two correlated Brownians
Given the stochastic differential equations
dx
1
= a
1
dt +b
1
dz
1
(2.37)
dx
2
= a
2
dt +b
2
dz
2
(2.38)
2.4. ITO’S LEMMA, THE PRODUCT RULE, AND A RECTANGLE 17
with a
1
= a
1
(x
1
, x
2
, t), a
2
= a
2
(x
1
, x
2
, t), b
1
= b
1
(x
1
, x
2
, t), b
2
= b
2
(x
1
, x
2
, t) where z
1
and z
2
are two corre-
lated Brownian motions with instantaneous correlation coefficient ρ (i.e. E[dz
1
dz
2
] = ρdt). Let f(x
1
, x
2
, t)
be twice continuously differentiable function of x
1
, x
2
and t. Then
df(x
1
, x
2
, t) =

f
t
+a
1
f
x1
+a
2
f
x2
+
1
2
b
2
1
f
x1x1
+
1
2
b
2
2
f
x2x2
+ρb
1
b
2
f
x1x2

dt +b
1
f
x1
dz
1
+b
2
f
x2
dz
2
(2.39)
Using vector notation we can generalize the above result
(⋆) Ito’s for vectors
Given a vector stochastic differential equation
dx = adt +Bdz (2.40)
(2.41)
where x ∈ R
n
, a = a(x, t) ∈ R
n
, B = B(x, t) ∈ R
n×m
and z ∈ R
m
a vector Brownian motion with
instantaneous covariance matrix E[dzdz
T
] = Σdt. Let f(x, t) be twice continuously differentiable function of
x and t. Then
df =

f
t
+f
x
a +
1
2
Tr(f
xx
BΣB
T
)

dt +f
x
Bdz (2.42)
where
f
x
= [f
x1
, f
x2
, ..., f
xn
] and f
xx
=

f
x1x1
· · · f
x1xn
.
.
.
.
.
.
.
.
.
f
xnx1
· · · f
xnxn
¸
¸
¸.
2.4 Ito’s lemma, the product rule, and a rectangle
In Ito’s lemma for Brownian motion, the mysterious term is
1
2
b
2
f
xx
dt, which enters because we are forced
to keep the dz
2
term which is of order dt. Without this term, Ito’s lemma would follow from the intuition
of ordinary calculus.
Let me give a little argument (which appears in Rogers and Williams [12]) to try to convince you that
Ito’s lemma is actually more intuitive than ordinary calculus. The example I will use is the product rule. In
ordinary calculus, we have the familiar formula
d(uv) = udv +vdu. (2.43)
In fact, this is the beginnings of the integration by parts formula. Let’s try to ”derive” this formula by a
simple ”rectangle” argument. Here it is.
Consider the quantity d(uv). This is a change in the product uv, that is
d(uv) = (u +du)(v +dv) −uv (2.44)
We can think of this as the area of a rectangle with sides of length u + du and v + dv minus the area of a
rectangle with sides of u and v. The rectangle in Figure 2.1 shows a picture of this. Now, it is obvious the
area of d(uv) is equal to the sum of the three colored rectangles in the figure. That is
d(uv) = udv +vdu +dudv. (2.45)
Hence, it is natural to expect to see a term related to dudv! In fact, it is more mysterious that in ordinary
calculus we are able to ignore this term. Of course, that is because in ordinary calculus, roughly speaking,
the terms du and dv are of order dt and hence dudv is a higher order term.
18 CHAPTER 2. ITO’S LEMMA
Figure 2.1: Ito’s Rectangle
Let us see how far we can get from this simple rectangle. Let us take u = v = z(t). Then our rectangle
formula (product rule) says that
d(z
2
) = d(z · z) = zdz +zdz +dz
2
. (2.46)
Note that the formula above is exact! Now, recalling that dz
2
should be replaced by dt as in the argument
of Section 2.1.3, we have
d(z
2
) = 2zdz +dt (2.47)
which is Ito’s lemma for f(z) = z
2
. This gives us a formula for d(z
2
). Now we can proceed and choose u = z
and v = z
2
. From our rectangle and the formula for d(z
2
) we have
d(z
3
) = d(z · z
2
) = zd(z
2
) +z
2
dz +dzd(z
2
) (2.48)
= z(2zdz +dt) +z
2
dz +dz(2zdz +dt) (2.49)
= 3z
2
dz + 3zdt +o(t) (2.50)
where in the last step we have placed higher order terms in o(t) and replaced dz
2
by dt. This is Ito’s lemma
for f(z) = z
3
.
Continuing on in this manner, we can easily derive Ito’s lemma for any polynomial of any order in z(t)!
At that point, we are not a far cry from Ito’s lemma for C
2
functions, as they can be approximated by limits
of polynomials. Hence, you see that Ito’s lemma is actually quite natural if you just remember the rectangle.
Furthermore, now you should have an easy time remembering Ito’s product rule d(uv) = udv +vdu +dudv.
2.5 Summary
Ito’s lemma is the most important result in stochastic calculus for derivative pricing. There are different
versions for Brownian motion and for Poisson processes. You should be familiar with both. Roughly speaking,
for Brownian motion, since the standard deviation of dz is of order

dt, second order terms in dz are of
order dt and cannot be ignored. This gives an extra term in Ito’s lemma compared to the ordinary chain
rule of calculus. For Poisson processes, most of the time no jumps are occurring and ordinary calculus is
fine. However, when a jump occurs, it causes a corresponding jump in any function of the Poisson process.
Thus Ito’s lemma for Poisson processes is simply a combination of the ordinary chain rule plus noting that
when the Poisson process jumps, any function of it has a corresponding jump.
2.6. PROBLEMS 19
2.6 Problems
Problem 2.6.1 Consider the Stochastic Differential Equation:
dx = a(x, t)dt +b(x, t)dz +Y dπ (2.51)
where z is Brownian motion and π is a generalized Poisson process with intensity λ and random jumps of
size Y . Let f(x, t) be a twice continuously differentiable function of x and t. Find a stochastic differential
equation for df. (i.e. what is Ito’s lemma in this case).
Problem 2.6.2 Multidimensional Ito Formula for Brownian Motion:
Consider the following vector Ito process:
dx = µdt +Kdz (2.52)
where x ∈ R
n
, µ ∈ R
n
, K ∈ R
n×m
and z ∈ R
m
where z is a vector Brownian motion of m uncorrelated
one-dimensional Brownian motions. Let f(x, t) : R
n
×R → R be a twice continuously differentiable function
of x and t. What is df? (Hint: Use the same Taylor series argument used in class, but this time you can
use E[dzdz
T
] = Idt where I ∈ R
m×m
is the identity matrix.)
Problem 2.6.3 Let
dx = adt +bdz
1
(2.53)
and
dy = fdt +gdz
2
(2.54)
where z
1
and z
2
are correlated Brownian motions with correlation coefficient ρ. (i.e. E(dz
1
dz
2
) = ρdt)
(a) Use Ito’s lemma to find d(xy).
(b) Use Ito’s lemma to find d(x/y).
Problem 2.6.4 Ito’s Lemma Practice
(a) Given dx = xdt +

xdz, use Ito’s lemma to derive df where f(x, t) = x
2
+t.
(b) Given dx = −xdt +dπ
α
, use Ito’s lemma to derive df for f(x, t) = t
2

x.
(c) Given
dx = (x +y)dt +xdz
1
(2.55)
dy = ydt +xdz
2
(2.56)
where E[dz
1
dz
2
] = ρdt. Use Ito’s lemma to derive df for a generic twice continuously differentiable
f(x, y, t).
Problem 2.6.5 Compute

T
0
z
t
dz
t
(2.57)
where z
t
is Brownian motion. (Hint: consider Ito’s lemma for z
2
.)
Problem 2.6.6 (Counter-intuition) Let
dx = axdt +bxdz (2.58)
Assume that a > 0. That is, the growth rate of E[x
t
] is positive. Now consider 1/x
t
. Is it possible for
E[1/x
t
] to also have a positive growth rate? Give conditions on a and b for when this is possible. Intuitively,
provide an explanation for this.
20 CHAPTER 2. ITO’S LEMMA
Problem 2.6.7 Intuition behind Ito’s lemma for Brownian motion. (This intuitive look at Ito’s lemma was
communicated to me by Muruhan Rathinam.)
Let
dx = adt +bdz (2.59)
then from Ito’s lemma f(x, t) satisfies
df = (f
t
+af
x
+
1
2
b
2
f
xx
)dt +bf
x
dz. (2.60)
Recall our heuristic derivation based on a Taylor expansion:
df = f
t
dt +f
x
dx +
1
2
f
xx
(dx)
2
+... (2.61)
or
df = f
t
dt +f
x
(adt +bdz) +
1
2
f
xx
(a
2
(dt)
2
+b
2
(dz)
2
+ 2abdtdz) +... (2.62)
(a) Compute the mean of df to lowest order in dt using the terms of the Taylor expansion shown above.
(b) Compute the standard deviation of the terms that contain randomness in the above expansion. That
is, compute the standard deviation of the dz, dtdz, (dz)
2
terms separately. Which term has standard
deviation of lowest order in dt? (Hint: The fourth moment of a N(0, σ
2
) is 3σ
4
.)
(c) Use this analysis to argue for the plausibility of Ito’s lemma, (2.60).
Problem 2.6.8 Show that (2.39) follows from (2.42).
Chapter 3
Standard Stochastic Differential
Equations with Solutions
In this chapter we review some stochastic differential equations that have closed form solutions. These are
also some of the stochastic differential equation models used for modeling asset prices and other relevant
financial variables. In these solutions, note the important role that Ito’s lemma plays. Most importantly,
not many stochastic differential equations have closed form solutions. Thus, these are stochastic differential
equations that everyone should know!
3.1 Geometric Brownian Motion
Geometric Brownian motion is the following stochastic differential equation where a and b are constants.
dx = axdt +bxdz. (3.1)
A closed form solution to geometric Brownian motion can be found as follows. By Ito’s lemma with f(x) =
ln(x) we have
d ln(x) = (a −
1
2
b
2
)dt +bdz. (3.2)
Since a and b are constants, integrating gives
ln(x
t
) −ln(x
0
) = (a −
1
2
b
2
)t +bz
t
(3.3)
which implies that
x(t) = e
(a−
1
2
b
2
)t+bzt
x(0). (3.4)
Note that geometric Brownian motion is a log-normal process. That is, from (3.3) in log-coordinates x(t) is
a Gaussian process with drift a −
1
2
b
2
and volatility b. Figure 3.1 shows a typical sample path of geometric
Brownian motion.
3.1.1 Stock Price Interpretation
Geometric Brownian motion is the standard model for continuous asset price movements. It comes from the
following. Let x(t) be the price of a stock. Then over the time period dt, the return r on the stock x(t) is
given by
r =
x(t +dt) −x(t)
x(t)
=
dx
x
. (3.5)
21
22 CHAPTER 3. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS
Figure 3.1: Typical Sample path of geometric Brownian motion.
Geometric Brownian motion models this instantaneous return as
dx
x
= adt +bdz (3.6)
where a and b are constants. Thus, the instantaneous return r over the next dt is Gaussian with
E[r] = adt, V ar(r) = b
2
dt. (3.7)
Thus, this is a very natural model of asset prices.
3.2 Geometric Poisson Motion
Geometric Poisson motion is the equivalent of geometric Brownian motion, but being driven by a Poisson
process,
dx = ax

dt + (b −1)x

dπ. (3.8)
The reason for the term b −1 is as follows. If the current value is x(t) and a jump occurs, then we will jump
by an amount (b − 1)x(t). Thus, we will jump to x(t) + (b − 1)x(t) = bx(t). Hence, by writing (b − 1) we
think of b as indicating the multiple of the current state that we will jump to if a jump occurs. That is,
a jump leads to the transition x(t) → bx(t). Note that if we didn’t use this convention, it would be a bit
messier.
Again, there exists a closed form solution that is obtained by changing to log coordinates. By Ito’s lemma
with f(x) = ln(x)
d ln(x) = adt + ln(b)dπ. (3.9)
Integrating leads to
ln(x(t)) −ln(x(0)) = at +ln(b)π(t) (3.10)
or
x(t) = e
at+ln(b)π(t)
x(0) = e
at
b
π(t)
x(0). (3.11)
Thus, this process is a Poisson process plus drift in log-coordinates.
3.3. A JUMP-DIFFUSION MODEL 23
3.2.1 A conditional lognormal version of geometric Poisson Motion
The following stochastic differential equation uses a compound Poisson process with a log normal jump size.
This results in a conditional log-normal process that is different from geometric Brownian motion. It is
modeled as
dx = ax

dt + (Y −1)x

dπ (3.12)
where Y = e
Z
is a lognormal random variable.
Once again, a change to log coordinates facilitates finding a closed form solution. Using Ito’s lemma with
f(x) = ln(x) gives
x(t) =

¸
e
at
π(t)
¸
i=1
Y
i
¸

x(0). (3.13)
But since Y is lognormal, we can write it as
¸
πt
i=1
Y
i
= e

π(t)
i=1
Zi
where Z
i
is normal. Hence we have
x(t) =

e
at+

π(t)
i=1
Zi

x(0) (3.14)
which, conditional on π(t), is a lognormal process.
3.3 A jump-diffusion model
The following stochastic differential equation uses a generalized Poisson process with a log normal jump size
and a Brownian motion. This results in a process that involves jumps and a diffusion term. It is known as
a jump-diffusion model.
dx = ax

dt +bx

dz + (Y −1)x

dπ (3.15)
where Y is a lognormal random variable. Again, using Ito’s lemma with f(x) = ln(x) gives the solution,
which is
x(t) = e
(a−
1
2
b
2
)t+bz(t)
π(t)
¸
i=1
Y
i
x(0). (3.16)
But since Y is lognormal, we can write it as
¸
π(t)
i=1
Y
i
= e

π(t)
i=1
Zi
where Z
i
is normal. Hence we have
x(t) =

e
(a−
1
2
b
2
)t+bz(t)+

π(t)
i=1
Zi

x(0) (3.17)
which, conditioned on π(t), follows the lognormal distribution.
This model is nice because it can produce distributions that have heavier tails (i.e. more extreme price
movements) than the log-normal distribution. In this way, it can be used to create implied volatility smiles
and smirks.
3.4 A more general SDE
The following SDE contains a slightly more general description of an SDE driven only by Brownian motion.
The intuition behind our route to the solution comes from the use of integrating factors in basic ODEs.
dx = (a +bx)dt + (c +fx)dz. (3.18)
To solve this, first write the SDE as follows:
dx −bxdt −fxdz = adt +cdz. (3.19)
24 CHAPTER 3. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS
In standard ordinary differential equations, we would try to make the left hand side an exact differential
by using an integrating factor. The integrating factor is usually related to the solution to the differential
equation if the right hand side of (3.19) is set to zero. That is,
dx −bxdt −fxdz = 0. (3.20)
The solution to this is
x(t) = x(0)e
(b−
1
2
f
2
)t+fz(t)
. (3.21)
Hence, we will try an integrating factor of the form
e
−(b−
1
2
f
2
)t−fz(t)
. (3.22)
Therefore, let us compute
d(e
−(b−
1
2
f
2
)t−fz(t)
x) = e
−(b−
1
2
f
2
)t−fz(t)

−(b −
1
2
f
2
)xdt −fxdz +
1
2
f
2
xdt
+(a +bx)dt + (c +fx)dz −f(c +fx) dt

= e
−(b−
1
2
f
2
)t−fz(t)
((a −fc)dt +cdz) . (3.23)
Integrating both sides leads to
e
(−(b−
1
2
f
2
)t−fz(t))
x(t) −x(0) =

t
0
e
(−(b−
1
2
f
2
)s−fz(s))
((a −fc)ds +cdz(s)) (3.24)
and rearrangement gives the final form
x(t) = e
((b−
1
2
f
2
)t+fz(t))
x(0) +

t
0
e
((b−
1
2
f
2
)(t−s)+f(z(t)−z(s))
((a −fc)ds +cdz(s)). (3.25)
3.4.1 The Ornstein-Uhlenbeck Process and Mean Reversion
A very useful model is one in which a price or financial variable is mean reverting. That is, the process is
pulled toward some value (in this case, its long term mean level). A standard model for this is a Gaussian
model called the Ornstein-Uhlenbeck process [14],
dx = −b(x −a)dt +cdz (3.26)
where a is the level that x(t) reverts to, and b is the mean reversion rate. Thus, x(t) is drawn toward a at a
rate of b. The Brownian driven term cdz just adds noise.
A sample path of a mean reverting process is depicted in Figure 3.2. Mean reverting processes of this
specific form are sometimes also called a Vasicek model. Vasicek used a process of this form to model the
short rate process in term structure modeling [15].
Since a mean reverting process is of the form of (3.18), it has a closed form solution. The solution is
given by
x(t) = e
−bt
x(0) +

t
0
e
−b(t−s)
(abds +cdz(s)). (3.27)
Thus, observe that x(t) is a Gaussian process as well. One disadvantage of this process is that values of x(t)
can become negative because the Gaussian distribution always has some probability of being negative. This
is undesirable because prices and quantities such as interest rates should not be negative.
3.5. COX-INGERSOLL-ROSS PROCESS 25
0 1 2 3 4 5
1.6
1.8
2
2.2
2.4
2.6
2.8
3
t
x
Simulation of Mean−Reversion Dynamics
Figure 3.2: Simulation of Mean-Reverting Dynamics, a = 2, b = 5, c = 0.5, x(0) = 3.
3.5 Cox-Ingersoll-Ross Process
Another version of a mean reverting process is the Cox-Ingersoll-Ross (CIR) process [4]. It is given by
dx = −b(x −a)dt +c

xdz (3.28)
and used often in short rate models or stochastic volatility type models. Note that it is very similar to the
Ornstein-Uhlenbeck process, except that the driving Brownin motion is multiplied by

x. This makes the
noise dependent on the size of x. Furthermore, with correct parameter values, this process will always be
positive.
This process is related to the Ornstein-Uhlenbeck process as follows. Consider n Ornstein Uhlenbeck
Processes
dy
1
= −
1
2
αy
1
dt +
1
2
βdz
1
(3.29)
.
.
. (3.30)
dy
n
= −
1
2
αy
n
dt +
1
2
βdz
n
(3.31)
where the Brownian motions z
1
, . . . , z
n
are uncorrelated. Now, consider the process
x(t) = y
2
1
(t) +. . . +y
2
n
(t) (3.32)
By Ito’s lemma, x(t) follows
dx =
n
¸
i=1
2y
i
(t)


1
2
αy
i
dt +
1
2
βdz
i

+
n
¸
i=1

β
2
4

dt (3.33)
=
n
¸
i=1

−αy
2
i
+
β
2
4

dt +
n
¸
i=1
(βy
i
dz
i
) (3.34)
=

−αx(t) +n
β
2
4

dt +β
n
¸
i=1
(y
i
dz
i
) (3.35)
26 CHAPTER 3. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS
Now, we perform a little trick by writing the last term as
β

x(t)
n
¸
i=1

y
i

x(t)
dz
i

. (3.36)
Now, it turns out that
n
¸
i=1

y
i

x(t)
dz
i

(3.37)
is actually a Brownian motion!
How can we see this? Well, note that if we interpret each Brownian increment as being normally dis-
tributed with mean zero and variance dt, i.e. dz
i
∼ N(0, dt), then (3.37) is just the sum of Gaussians. But,
it is a well known property that the sum of Gaussians is Gaussian. Thus, (3.37) is normally distributed. For
it to be the increment of Brownian motion, heuristically, we only need to show that the mean is zero and
the variance is dt. To compute the mean we have
E
¸
n
¸
i=1

y
i

x(t)
dz
i
¸
=
n
¸
i=1

y
i

x(t)
E[dz
i
]

= 0 (3.38)
and the variance is computed as
V ar
¸
n
¸
i=1

y
i

x(t)
dz
i
¸
=
n
¸
i=1

y
2
i
x(t)
V ar(dz
i
)

=
n
¸
i=1

y
2
i
x(t)
dt

=
dt
x(t)
n
¸
i=1
y
2
i
= dt (3.39)
where we used that the dz
i
’s are independent and equation (3.32). Thus we can actually use the replacement
dz =
n
¸
i=1

y
i

x(t)
dz
i

(3.40)
to convert (3.35) to
dx =

−αx(t) +n
β
2
4

dt +β

x(t)dz (3.41)
Now, it turns out that for n ≥ 2, we are guaranteed to have a positive process (otherwise the process can
and will reach zero at times!). Hence, we should always make sure that our parameter choices correspond
to selecting n ≥ 2.
This is easily done since we can match coefficients in (3.28) and (3.41). This gives
ab =

2
4
, b = α, c = β (3.42)
From these relationships, we get that n =
4ab
c
2
.
For n corresponding to an integer, we have the solution as the sum of Ornstein-Uhlenbeck processes.
Thus, overall, the process x(t) will be Chi-Squared distributed. A sample path of a CIR process is depicted
in Figure 3.3.
3.6 Summary
In this chapter we have explored some of the standard stochastic differential equation models used in finance.
It is important to have a feel for these processes what their parameters correspond to. Note that most of them
correspond to some transformation of simple Gaussian processes such as the Ornstein-Uhlenbeck process or
the Poisson process. You can think of these models as building more and more complicated models from our
basic building blocks of Brownian motion and the Poisson process.
3.7. PROBLEMS 27
0 1 2 3 4 5
1.5
2
2.5
3
t
x
Simulation of CIR Dynamics
Figure 3.3: Simulation of a sample path of a CIR process, a = 2, b = 5, c = 0.5, x(0) = 3.
3.7 Problems
Problem 3.7.1 Solve the following stochastic differential equations:
(a) dx = µdt +σxdz
(b) dx = µxdt + σxdz + x(Y − 1)dπ where π is a Poisson process with intensity λ and Y is a random
variable.
(c) What does your answer in (b) look like if Y is log-normally distributed.
Problem 3.7.2 Consider the process
dx = −b(x −a)dt +cdz (3.43)
Using Ito’s lemma, derive a stochastic differential equation for y = e
x
in terms of only y. This model is
log-normal due to the fact that x is normal, but has a mean reverting property in log coordinates.
Problem 3.7.3 Verify equation (3.23). (Hint: Let f(x, z, t) = e
−(b−
1
2
f
2
)t−fz
x where z has the trivial sde
dz = dz and use the multidimensional Ito’s lemma.)
28 CHAPTER 3. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS
Chapter 4
The Factor Approach to Arbitrage
Pricing
4.1 The Factor Approach to Arbitrage Pricing
In this chapter we present absence of arbitrage conditions when returns are described by linear factor models.
In doing so, we rely heavily on Ross’ Arbitrage Pricing Theory [13]. However, we do so in light of the
application to derivative pricing. We will find in the following chapters that when coupled with Ito’s lemma,
a simple absence of arbitrage equation results in perhaps the simplest way to obtain the vast majority of
Black-Scholes type pdes that appear in derivative pricing. To back up this claim we will derive pdes in a
great number of situations. But first we must understand the underlying principle, which is in fact quite
simple. Let’s begin...
4.2 Returns and Factors Models
Most of the modeling in asset pricing theory is done using linear factor models. Hence, we adopt that
paradigm here. That is, a return is assumed to be of the form
r = α +βf (4.1)
where a and b are constants and f is a random variable called a factor. This is a one factor model. We will
also consider multifactor models of the form
r = α +
n
¸
i=1
β
i
f
i
(4.2)
where each f
i
, i = 1, ..., n is a random factor.
4.2.1 Returns
Above I said we would model returns as factor models. However, returns are also related to price changes.
Hence, factor models should arise from price changes as well.
Given a period of time ∆t, the return on an asset is defined as
r =
P(t + ∆t) −P(t)
P(t)
(4.3)
where P(t) is the amount invested at time t and P(t + ∆t) is the amount received at time t + ∆t. Figure
4.1 shows the cash flow diagram corresponding to this where the time increment it denoted as dt.
29
30 CHAPTER 4. THE FACTOR APPROACH TO ARBITRAGE PRICING
Figure 4.1: Cash Flow Diagram
4.2.2 Stochastic differential equations and factor models
In finance, we like to model asset prices as stochastic differential equations. For instance, a stock price could
be
dS = µSdt +σSdz. (4.4)
This is a model of a price change over time dt. Hence, I should be able to use it to compute the return of
an asset over time dt. In fact, it is given by:
r =
S(t +dt) −S(t)
S(t)
=
dS(t)
S(t)
= µdt +σdz. (4.5)
This is also an example of a factor model. In the above formula, if we associate α = µdt, β = σ, and f = dz
then it is a standard linear factor model.
In general, if I am given a stochastic differential equation
dx(t) = a(x(t), t)dt +b(x(t), t)dz (4.6)
then it is describing price changes over time period dt, and I can use it to determine a model of returns:
r =
dx(t)
x(t)
=
a(x(t), t)
x(t)
dt +
b(x(t), t)
x(t)
dz (4.7)
This also looks like a factor model with the factor being dz. In fact, I like to write it in the form:
r = αdt +βdz (4.8)
where α =
a(x(t),t)
x(t)
and β =
b(x(t),t)
x(t)
(and arguments are being suppressed). This is slightly different from
the standard factor model in that I explicitly write out dt in the first term. I like to go even a little further
and interpret dt as a special factor which is non-random. This is purely for convenience, but I will use this
convention throughout.
Another note is that α and β don’t seem to be constant! However, we should view a factor model from
an SDE as being valid only over dt and conditioned upon information at time t, including x(t) (or t− and
x(t−) if appropriate). Therefore, conditioned upon information at time t, x(t) is known and α and β are
then known constants over time t to t +dt.
Therefore, SDEs lead to instantaneous factor models that apply over time increments of dt. In what
follows, I will use notation that is indicative of SDEs in that factors will be denoted by dz and I will include
a special factor dt when I describe returns. However, for the sections that follow, you may think of the factor
dz as being any random variable, not just Brownian motion, and dt can be any time increment, not just an
instantaneous change in time.
4.3. THE FACTOR APPROACH TO ARBITRAGE USING RETURNS 31
4.3 The Factor Approach to Arbitrage using Returns
We consider the returns of tradable assets. By a tradable asset, I mean an asset that you can actually buy.
For instance, you can purchase a share of stock. If this stock pays a dividend, then when you purchase the
share of stock, you have purchased the dividend stream as well. Note that you cannot just purchase the
”price” of the stock, only a share, and hence you are stuck with everything that comes along with purchasing
a share (such as dividends). So, let’s consider the returns of tradable assets.
Let’s list the returns of tradable assets that are driven by the factor dz
r = αdt +βdz (4.9)
where r ∈ R
n
, α ∈ R
n
are vectors and β ∈ R
n×m
is a matrix. The factors are contained in the vector
dz ∈ R
m
. That is, I have stacked up all the returns in a vector.
Now consider a portfolio of these assets. We will represent the portfolio by a vector x ∈ R
n
which denotes
the dollar amount invested in each tradable asset. Hence, the total cost of our portfolio is
cost =
n
¸
i=1
x
i
= x
T
1 (4.10)
where 1 is a vector of ones.
Over the time period dt, the returns in (4.9) indicate the change in value of each tradable asset. Hence,
the total change in our portfolio is given by:
profit/loss =
n
¸
i=1
x
i
r
i
= x
T
r. (4.11)
We can analyze this return in a little more detail by writing out what each r
i
is
x
T
r = x
T
(αdt +βdz) = (x
T
α)dt + (x
T
β)dz. (4.12)
We can now see that this return will be riskless as long as
x
T
β = 0 (4.13)
since that is the coefficient of the dz term which is providing the randomness. If x
T
β = 0 then the return
on this portfolio is deterministic and given by x
T
αdt.
4.3.1 Arbitrage
Let us consider a simple portfolio. I will choose this portfolio so that it costs nothing and has no risk. That
is
x
T
1 = 0 No cost (4.14)
x
T
β = 0 No risk (4.15)
But, if something costs nothing and has no risk, then it better have no return! If it had a positive return, this
would be an arbitrage, since I would be guaranteed to make money (no risk), and I didn’t use any money to
do it (no cost). If it had a negative return, then the portfolio −x would be an arbitrage. Therefore, to have
no arbitrage, I must have no return as well. This leads us to a key condition which I state as the following
implication
(⋆) A (not very useful) Necessary Absence of Arbitrage Condition
x
T
1 = 0 No cost
x
T
β = 0 No risk

⇒ x
T
α = 0 No return (4.16)
32 CHAPTER 4. THE FACTOR APPROACH TO ARBITRAGE PRICING
which can be written in matrix form as
¸
1
T
β
T

x = 0 ⇒ α
T
x = 0. (4.17)
As the name indicates, the above condition for absence of arbitrage is not terribly useful. However, an equiv-
alent condition is extremely useful and will provide the foundation for our derivations of partial differential
equations. In fact, the condition which is stated next is astonishingly useful! But to derive it, we need to
first recall some linear algebra relationships.
4.3.2 Null and Range Space Relationship
Note that the condition (4.17) can be written as
Ax = 0 ⇒ α
T
x = 0 where A =
¸
1
T
β
T

. (4.18)
Now, the set of all vectors x such that Ax = 0 is known as the null space of the matrix N(A). That is
N(A) = {x|Ax = 0} . (4.19)
On the other hand, the set of all vectors y such that there exists an x with y = Ax is known as the range
space of the matrix A. That is
R(A) = {y | ∃x such that Ax = y } . (4.20)
Finally, we recall the notion of the perpendicular set of a given set of vectors. Let M be a set of vectors,
then M

is a set of all vectors z such that z is orthogonal to all vectors in M. That is
M

=
¸
z | z
T
x = 0, ∀x ∈ M
¸
(4.21)
In order to derive a useful condition from (4.17), we will use the following relationship between the null
and range space of a matrix.
(⋆) Null and Range Space Relationship: N(A)

= R(A
T
).
Proof: The proof of this is rather simple.
x ∈ N(A) ⇒ Ax = 0 ⇒ y
T
Ax = 0 for all y. (4.22)
Then
y
T
Ax = (A
T
y)
T
x = 0 (4.23)
which means that A
T
y is orthogonal to the null space of A for all y. That is exactly saying that
N(A)

= R(A
T
). (4.24)
2.
4.3.3 A Useful Absence of Arbitrage Condition
Using the null and range space relationship, we can convert (4.17) into a very useful condition. It’s importance
cannot be overstated. Hence it receives two stars!!
(⋆⋆ Return APT) A Useful Necessary Absence of Arbitrage Condition
4.3. THE FACTOR APPROACH TO ARBITRAGE USING RETURNS 33
A necessary and sufficient condition for the implication (4.16) to be true is for there to exist a vector
ˆ
λ ∈ R
m+1
such that

1 β

ˆ
λ = λ
0
+βλ = α (4.25)
where
ˆ
λ =
¸
λ
0
λ

(4.26)
with λ
0
∈ R and λ ∈ R
m
.
Many of you will hopefully recognize this as nothing more than the simple version of Ross’ 1976 arbitrage
pricing theory [13]. Its derivation is given below.
Proof: Note that the condition in (4.17) indicates that if a portfolio x is in the null space of the matrix
¸
1
T
β
T

then it also must be orthogonal to α. Another way to put this is that
α ∈

N
¸
1
T
β
T


(4.27)
where N(·) is the null space. But, using the null and range space relationship, this means that
α ∈ R

¸
1
T
β
T

T

(4.28)
Thus, there exists a vector
ˆ
λ ∈ R
m+1
such that [ 1 β ]
ˆ
λ = α. 2
4.3.4 Interpretations
Let’s try to get a bit of intuition into the mystical λ’s.
Market Price of Risk
The APT equation for a single factor model r = µdt +σdz is
µ = [ 1 σ ]
ˆ
λ = λ
0
+σλ
1
. (4.29)
Let’s look at this equation. On the left side is the expected return (µ), and on the right side is the volatility
(σ). Hence, this equation relates volatility to expected return.
A better way to think of σ is not as volatility, but as the amount of the risk factor dz that you have. If
σ is zero, then you are not exposed to the risk dz at all. If it is large, then you have purchased a lot of that
risk. Therefore, λ
1
tells you how much your expected return is increased (assuming λ
1
is positive) for each
unit of the risk dz that you take on. For this reason, λ
1
is called the ”market price of risk”. In this case, λ
1
is the market price of the risk factor dz. This is a nice interpretation for λ
1
.
The Market Price of Time
But, we also have this pesky λ
0
to deal with. It is not tied to any risk. In fact, if we don’t take on any risk
(i.e. σ = 0), then µ = λ
0
. Intuitively, if we don’t have any risk, then we should be earning the risk free rate.
Hence, we might guess that λ
0
= r
0
, where r
0
denotes the risk free rate of interest. This is in fact correct.
But, let’s justify this through a slightly different argument that will also get us a nice interpretation for λ
0
.
34 CHAPTER 4. THE FACTOR APPROACH TO ARBITRAGE PRICING
Let us consider a risk free asset. Its factor model is given by:
dB
0
B
0
= r
0
dt (4.30)
where r
0
is a constant risk free rate of interest. Since it must satisfy our return relationship, we have:
r
0
= λ
0
+ 0(λ
1
) = λ
0
(4.31)
which tells us that λ
0
= r
0
. If the λ’s are the market prices of factors, then we may interpret λ
0
as the
reward for the time factor dt or the ”market price of time”. Intuitively, this makes perfect sense, since the
risk free rate is the amount we are rewarded for taking on time and nothing else.
Now all the λ’s should make sense. They relate the different factors dt, dz, etc. to how much we are
rewarded for taking on those factors. In a market with no arbitrage, every factor has a market price. Your
return is just given by looking at how much of each factor you have taken on, and multiplying them by their
market price and adding them up. Quite simple, right?
This is the basic interpretation of the concept of ”market price of risk”. Don’t forget it. It is very useful
to have this intuition.
4.3.5 A Problem with Returns
Using returns to model assets has a disadvantage. There are contracts that involve no up-front cost or price.
Hence, they don’t have a well defined return, since by definition a return involves dividing by the price,
which can be zero. A futures contract is an example of this, since the mark-to-market mechanism resets the
value of a contract to zero every day. Therefore, in the above framework, a futures contract must be dealt
with as a special case. I don’t like special cases, so below we will reformulate absence of arbitrage conditions
but in terms of price changes rather than returns. This eliminates the need for special cases.
4.4 The Factor Approach using Price Changes
I just mentioned that there can be some problems in dealing with returns. Hence, in this section we will
reformulate the factor approach to arbitrage pricing by working with prices rather than returns. In this case,
it will be okay to have an asset with a zero price.
4.4.1 Price Changes and Arbitrage
Let’s return to our arbitrage portfolio and reformulate it in terms of price changes. In our original argument,
we let r ∈ R
n
be the returns of assets and specified the dollar amount invested in each asset by a vector
x ∈ R
n
. This time we will specify a vector of prices per unit of tradables P ∈ R
n
, cash flows resulting from
the changes in value of the tradables per unit dV ∈ R
n
, and shares or units of each asset purchased y ∈ R
n
.
The cash flow from changes in value over the period will satisfy the factor model
dV = Adt +Bdz (4.32)
where A ∈ R
n
, B ∈ R
n×m
, and dz ∈ R
m
. The simple cash flow diagram is given in figure 4.2.
4.4.2 Profit/Loss and Arbitrage
In this case, the profit/loss on the portfolio is given by:
y
T
(dV) = y
T
(Adt +Bdz) = (y
T
A)dt + (y
T
B)dz (4.33)
Therefore, an arbitrage portfolio is one that has:
4.4. THE FACTOR APPROACH USING PRICE CHANGES 35
Figure 4.2: Cash Flow Diagram with Prices P and Value Changes dV
• No Cost: y
T
P = 0,
• No Risk: y
T
B = 0,
but has a profit
• Profit: y
T
A = 0.
Of course, we want to eliminate arbitrages, so we would like the following implication to hold.
(⋆) A (not very useful) Necessary Absence of Arbitrage Condition
y
T
P = 0 No cost
y
T
B = 0 No risk

⇒ y
T
A = 0 No return (4.34)
which can be written in matrix form as
¸
P
T
B
T

y = 0 ⇒ A
T
y = 0. (4.35)
Once again, we can convert this to a dual condition that is useful:
(⋆⋆Price APT) A Useful Necessary Absence of Arbitrage Condition
A necessary condition for no arbitrage is for there to exist a vector
ˆ
λ ∈ R
m+1
such that

P B

λ = Pλ
0
+Bλ = A (4.36)
where
ˆ
λ =
¸
λ
0
λ

(4.37)
with λ
0
∈ R and λ ∈ R
m
.
What is the relationship between the return approach and the price change approach. Well, of course
they are highly related. The λ’s in both cases are the same, and have the same interpretation. They are
market prices of risk. The main difference is that the price approach uses shares or units of the asset to
describe the portfolio, not dollar amount. Furthermore, it describes profit/loss in terms of the cash flow, not
returns. These are really superficial differences, but it is easier to understand some pricing situations, such
as futures contracts, in the price approach rather than in terms of returns.
36 CHAPTER 4. THE FACTOR APPROACH TO ARBITRAGE PRICING
4.5 Two standard examples
In this section we will give some little examples to help us gain some intuition into the approach. Let’s start
with a stock and a bond.
4.5.1 Stocks
Assume that a stock follows a geometric Brownian motion (GBM) and there is a bond that earns the risk
free rate, r
0
. Their dynamics are given below:
dB = r
0
Bdt (4.38)
dS = µSdt +σSdz. (4.39)
What do our absence of arbitrage conditions say about these assets?
Returns
In terms of returns, we can write that:
dB
B
= r
0
dt (4.40)
dS
S
= µdt +σdz (4.41)
Hence, the APT equation says [ 1 β ]
ˆ
λ = α or
¸
1 0
1 σ
¸
λ
0
λ
1

=
¸
r
0
µ

(4.42)
Solving this equation for λ
0
and λ
1
gives
λ
0
= r
0
(4.43)
λ
1
=
µ −r
σ
(4.44)
Note that the market price of risk for dz is like an instantaneous Sharpe ratio. We will see this equation pop
up many times.
Prices
We can derive the same results using prices. In terms of prices and changes in value, the absence of arbitrage
equation says that [ P B ]
ˆ
λ = A or
¸
B 0
S σS
¸
λ
0
λ
1

=
¸
r
0
B
µS

(4.45)
Solving this equation for λ
0
and λ
1
gives
λ
0
= r
0
(4.46)
λ
1
=
µ −r
σ
, (4.47)
as expected.
4.6. SUMMARY 37
4.5.2 Futures contracts
One can enter into a futures contract without paying any money. This means that a futures contract is a
special case in our setup, and is difficult to understand in the context of returns because its return is not
defined (it has zero price!). It is much more naturally considered in terms of prices and value changes. Below
is the cash flow diagram for a futures contract.
The critical difference between futures contracts and forward contracts is that futures contracts are
marked to market and settled daily. This means that they always begin the day with a zero price. At the
end of the day, the price change is settled. Note that this price change is not discounted, but rather the
change in the futures price. Hence, the change in value of the portfolio is equal to the change in the futures
price dV = df!
Figure 4.3: Cash Flow Diagram for Futures Contract
Therefore, a futures contract can have zero price, but the cash flow from the change in value will be given
by
df = µfdt +σfdz. (4.48)
Hence, in this case, we may consider a market with a bond and a futures contract. The relevant quantities
can be written as
prices changes factors
B dB = r
0
Bdt
0 df = µfdt +σfdz.
(4.49)
Now let’s look at the price based arbitrage equation [ P B ]λ = A or
¸
B 0
0 σS
¸
λ
0
λ
1

=
¸
r
0
B
µS

. (4.50)
Solving this equation for λ
0
and λ
1
gives
λ
0
= r
0
(4.51)
λ
1
=
µ
σ
. (4.52)
Note that a futures contract refers to the price at a fixed time in the future. Hence, time is fixed, and a
futures contract is purely a bet on the outcome of a random factor. Time is not in the mix. Hence, we see
that the equations separate. The bond is purely time, and the market price of time is r
0
. On the other hand,
the futures contract is purely a bet on the outcome of the factor. Hence time is not mixed into it, and the
market price of risk does not involve the risk free rate r
0
.
4.6 Summary
We have derived forms of an aribtrage pricing theory based either on linear factor models of returns or
value changes. These simple results will allow us to derive many of the partial differential (or differ-
ence/integral/etc.) equations that arise in derivative pricing theory. But before doing so, we develop a
38 CHAPTER 4. THE FACTOR APPROACH TO ARBITRAGE PRICING
derivative pricing framework based upon our APT factor based approach. Then, in following chapters we
tackle examples in equity derivatives, interest rate derivatives, and beyond. What you should take away is
that simple arbitrage ideas that we derived in this chapter are the underpinnings of derivative pricing theory.
4.7 Problems
Problem 4.7.1 (How to construct an arbitrage)
Assume that there does not exist a λ such that α = [1 β]λ. Then this means that an arbitrage opportunity
exists. That is, there exists a vector x specifying dollar amounts invested such that
α
T
x > 0 and 1
T
x = 0, β
T
x = 0. (4.53)
One way to select a specific arbitrage would be to solve an optimization problem of the form
max
x
α
T
x subject to 1
T
x = 0, β
T
x = 0, x
1
= 1. (4.54)
where the constraint x
1
limits the total dollar amount of long and short positions to equal $1. However,
in practice an alternative but equivalent approach is often used, as follows.
Choose λ such that α −[1 β]λ has minimum 2-norm. That is
min
λ
α −[1 β]λ
2
. (4.55)
If λ

is this optimal λ, then we can define
γ = α −[1 β]λ

. (4.56)
One could then solve the optimization problem
max
x
γ
T
x subject to 1
T
x = 0, β
T
x = 0, x
1
= 1. (4.57)
Show that this optimization problem is equivalent to the optimization problem in (4.54).
Problem 4.7.2 (More Linear Algebra and Dualities)
The Farkas Alternative [7] of linear algebra says the following
(i) Ax = b has a solution x ≥ 0
or (exclusive)
(ii) y
T
A ≥ 0, y
T
b < 0 has a solution y.
(4.58)
We can use the Farkas Alternative for implications as well. Consider the implication:
Ax = 0 ⇒ b
T
x = 0 (4.59)
Prove by use of the Farkas alternative that this implication is true if and only if there exists a λ such that
b = A
T
λ. (4.60)
(Hint: Note that the implication is true if and only if there is no solution to Ax = 0 and b
T
x > 0.)
Problem 4.7.3 (Early Exercise and American Options)
American options allow the holder of the option to exercise at any time prior to expiration. Let’s explore
how this would affect the absense of arbitrage ideas.
4.7. PROBLEMS 39
(a) Assume that the factor model for the option if it is not exercised is
r
1
= α
c
dt +β
c
dz. (4.61)
Explain why the factor model for the return on an American option, where E is the early exercise value and
c is the price of the option, is either
r
1
= α
c
dt +β
c
dz or r
1
=
E −c
cdt
dt (4.62)
depending on whether the option is exercised or not.
(b) Assume that you are long the American option. As the holder of an American option, you get to decide
when to exercise the option. Let α and β correspond to factor models for tradable assets, where the first
elements of these vectors α
1
and β
1
corresponds to the American option. Finally, let x be a vector of dollar
amounts invested in each asset (with x
1
corresponding to the American option).
Argue that a necessary condition for you not to be able to arbitrage is that the following implication is
true regardless of whether you are exercising the American option or not,
e
1
T
x = 1, 1
T
x = 0, β
T
x = 0 ⇒ α
T
x ≤ 0. (4.63)
(I.e., the implication must hold regardless of which return in (4.62) is being chosen.)
(c) Assume that the vectors e
1
, 1, β are linearly independent. Using the Farkas Alternative from Problem
4.7.2, derive that an alternative absence of arbitrage condition is that there exists scalars ξ ≥ 0, and λ
0
and
λ
1
such that
α = λ
0
+βλ
1
−e
1
ξ. (4.64)
(d) Finally, using (4.64) and Part (a) of this problem, argue that for the American option, both of the
following conditions must hold
α
c
≤ λ
0

c
λ
1
(4.65)
E ≤ c. (4.66)
Problem 4.7.4 (Modeling the binomial lattice as a factor model)
Consider a stock that can move on a binomial lattice, where at each step the stock price S(k) can either
move up to S(k + 1) = uS(k) or down to S(k + 1) = dS(k) with the probability structure
S(k + 1) =

uS(k) w.p. p
dS(k) w.p. 1 −p
(4.67)
Let ∆Z(k) be a standard binary random variable
∆Z(k) =

1 w.p. p
−1 w.p. 1 −p
(4.68)
Show that ∆S(k) = S(k + 1) −S(k) can be written in the form
∆S(k) = A(k) +B(k)∆Z(k) (4.69)
by finding A(k) and B(k).
40 CHAPTER 4. THE FACTOR APPROACH TO ARBITRAGE PRICING
Chapter 5
Constructing a Factor Pricing
Framework
5.1 Introduction
This chapter lays the framework for derivative pricing. That is, we try to provide the structure behind the
factor approach. Thus, the goal is to clarify the structure of the modeling involved in the factor approach,
and to provide an almost step by step method for attacking any problem.
As I proceed through this chapter, I will use two derivative pricing examples to illustrate points. The
examples are a call option on a non-dividend paying stock, and an absence of arbitrage zero coupon bond
pricing model. In particular, I will also emphasize the relative pricing nature of derivative pricing. That is,
derivative pricing determines an appropriate price relative to other securities that have already been priced
in a market. Before jumping into any of these ideas of derivative pricing, let’s start by classifying the relevant
quantities in a model of any market.
5.2 A Classification of Quantities
In this book, we will be interested in the pricing of derivative securities. However, to understand that pricing
theory, it is best to first understand the general modeling paradigm.
In our modeling framework, we will classify all quantities into three (possibly overlapping) categories.
They are factors, underlying variables, and tradables.
5.2.1 Factors
Factors are the most basic source of randomness in our models. In general, they are the driving Brownian
motions (z(t)) and Poisson processes (π(t)). Furthermore, I like to think of time as a special factor. Thus,
in our models, the factors will show up as the dz, dπ, and dt terms.
5.2.2 Underlying Variables
Underlying variables are often quantities of interest that are functions of the factors. For example, an interest
rate could be an underlying variable. A stock price S(t) could also be an underlying variable. In general,
underlying variables are financially relevant quantities that are functions of the factors, and used in the
modeling process.
41
42 CHAPTER 5. CONSTRUCTING A FACTOR PRICING FRAMEWORK
5.2.3 Tradables
Tradables are the quantities that you can actually trade and include in a portfolio. They are modeled
as being functions of the underlying variables. Some of the time, the functional relationship between the
tradable and an underlying variable is trivial. For example, a stock price S(t) can be an underlying variable,
and also a tradable. In other cases, the tradable is a more complicated function of an underlying variable.
For example, an interest rate r(t) can be an underlying variable, but it is not tradable. Instead, a bond
B(r(t), t) is tradable, and represented as a function of the underlying variable.
Figure 5.1: Picture of the Modeling Paradigm
It is extremely important to be able to separate quantities that are tradable from those that are not.
Why? Because tradables, and only tradables, are the quantities that must satisfy the absence of arbitrage
relationships from the previous chapter. And those absence of arbitrage relationships will lead to our pricing
formulas.
Let’s consider an example to clarify the notion of what is tradable.
Example: A stock paying a dividend
To make sure we understand what a tradable is, let’s consider the example of a stock that pays a dividend.
The stock has price S(t), and let’s assume that it pays a continuous dividend at a rate of q. What this means
is that by reinvesting the dividend back into the stock, if you started by purchasing 1 share of stock at time
0, by time t you would have e
qt
shares.
What is the tradable quantity? You might be tempted to say that the price of the stock S(t) is tradable.
However, note that you cannot just purchase the ”price of the stock”. Instead, you must purchase a share
of stock, and with this share you not only get the price of the stock but also the dividend. The point is that
you can’t decouple the price from the dividend. They come together and that is the tradable.
5.2.4 A Derivative is a Tradable
In this book we are interested in pricing derivative securities. So, it is important to begin by defining what
we mean by a derivative security.
Derivative Security: A derivative security is a tradable whose value depends upon (or is a function of)
other underlying variables. In this case, we say that the derivative security is derivative to the underlying
variables.
Note that this definition of a derivative does not particularly distinguish it from any other tradable! We
typically model all tradables as being a function of some underlying variables (although often a tradable is
an underlying variable and hence trivially a function of itself).
In principle, there is no real distinction between a derivative and any other tradable. You will see that
the most important distinction is that a derivative is ”what you want to price” and that other tradables are
”already priced” in the market.
The name derivative comes from the fact that the value of a derivative is ”derived” from some underlying
variables. In order to have something to keep in mind, let’s use the following example:
5.3. FACTOR MODELS FOR UNDERLYING VARIABLES AND TRADABLES 43
Example: European Call Option
Consider a European call option, which is the option to purchase a specified stock, say Coca-Cola, for a
specified price (the strike price), at a specified date (the expiration date). In this case, the option is a
derivative, because its value depends upon the stock price of Coca-Cola. Thus, the stock price of Coca-Cola
is the underlying variable.
In this example, Coca-Cola is an underlying variable and also a tradable. However, it is not always the
case that the underlying variable must also be tradable. In general, derivative securities are quite flexible, and
so are the possible underlying variables. In fact, there are derivatives that depend on underlying variables
such as temperature or even wind speed which clearly are not tradable.
5.3 Factor Models for Underlying Variables and Tradables
To use the APT equations from the previous chapter, what we need are linear factor models for the price
changes of tradables. In the previous chapter we saw that we can interpret SDEs as instantaneous factor
models. Hence, in continuous time models, we would like SDE models for underlying variables and tradables
in particular.
In general, there are two ways that we arrive at factor models for tradables. The first is that we directly
model the tradable as a factor model. The second (and most important) is Ito’s lemma.
5.3.1 Direct Factor Models
In many cases, we begin the modeling process by writing down a factor model or SDE. Examples of this
include the geometric Brownian motion model of stock price movement.
dS = µSdt +σSdz (5.1)
or a model of an interest rate (most likely the instantaneous short rate) as an SDE
dr
0
= adt +bdz. (5.2)
Thus, in many case, we begin the modeling process by writing down SDEs (or factor models) for underlying
variables and tradables.
5.3.2 Factor Models via Ito’s Lemma
The second method to obtain factor models is via Ito’s lemma. Since tradables, and derivatives in particular,
are functions of underlying variables, if we have an SDE model for an underlying then we can use Ito’s lemma
to obtain an SDE for the tradable.
Consider the example of a European call option on a stock following geometric Brownian motion as in
(5.1). The call option is a function of the underlying stock price S(t) and time t. We write this as c(S(t), t).
Then, by Ito’s lemma we have
dc = (c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
)dt +σSc
S
dz (5.3)
which is a factor model for the call option c.
In some cases, we will know explicitly the functional relationship between the tradable or derivative and
the underlying variable. In that case, in Ito’s lemma we would be able to explicitly compute the partial
derivative terms c
t
, c
S
, etc.
A picture of the route to SDEs for tradables is given in Figure 5.2
44 CHAPTER 5. CONSTRUCTING A FACTOR PRICING FRAMEWORK
Figure 5.2: Obtaining factor models or SDEs for tradables.
5.4 Tradables tables
We will approach the derivative pricing problem using the Price APT equation (4.36), rather than the Return
APT. But note that everything in this book can also be done use the Return APT equation.
To use the Price APT equation, we need two things: prices and factor models for value changes. The
previous section indicated how to obtain the factor model for value changes. Thus, we can tabulate prices
and factor models for value changes for all tradables. When we list these in a table, we call this a tradable
table. For instance, in a market with a stock, a bond, and a call option on the stock, the tradable table is
Prices

B
S
c
¸
¸
Changes
d

B
S
c
¸
¸ =
Factor Model

r
0
B
µS
(c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
)
¸
¸
dt +

0
σS
σSc
S
¸
¸
dz
(5.4)
This is called a tradable table to emphasize the fact that only tradables need satisfy the absence of arbitrage
conditions. It supplies all the basic information that we need to extract from the market when applying the
Price APT.
5.5 Applying the Price APT
The final step to a derivative pricing equation is to apply the Price APT equations. However, before applying
the Price APT equation, we first separate marketed tradables from the derivative the we would like to price.
5.5.1 Relative Pricing and Marketed Tradables
Once we have set up the tradables table, we designate certain tradables as marketed. What we mean by a
marketed tradables is a tradable that is ”already priced” by the market.
You should contrast the marketed tradables with the derivative that we would like to price. The derivative
is what we ”want to price” using the information given from the marketed assets. This emphasizes the relative
pricing nature of derivative pricing. We price a derivative security relative to the marketed tradables. That
is, derivative pricing is a method of pricing a new tradable (the derivative) consistently with the existing
price of marketed tradables.
To see how this works, we separate the marketed tradables from the derivative, and put them all in a
tradables table.
Prices
¸
P
m
P

Changes
d
¸
V
m
V

=
Factor Model
¸
A
m
A

dt +
¸
B
m
B

dz
(5.5)
5.5. APPLYING THE PRICE APT 45
The tradables with the subscript m are the marketed tradables, and the tradable without any subscript is
the derivative that we are pricing.
5.5.2 Pricing the Derivative
Now we can use the Price APT to price the derivative. The Price APT equation says there needs to exist
λ
0
and λ such that
A
m
= P
m
λ
0
+B
m
λ (5.6)
A = Pλ
0
+Bλ. (5.7)
To obtain the market prices of risk λ
0
and λ, we only use the marketed tradables. Thus, we solve (5.6) to find
the market prices of risk (often in terms of information from the marketed tradables). The market prices of
risk are then plugged into (5.7) which is the pricing equation for the derivative.
One may think of this procedure as first calibration to market data, followed by pricing the new derivative.
Using marketed tradables to determine the market prices of risk is like calibrating parameters (market prices
of risk) in our absence of arbitrage pricing model to known data (marketed tradables). Once our model is
calibrated (the market prices of risk are determined), we can apply our absence of arbitrage model to price
other tradables (derivatives) that also must satisfy the same absence of arbitrage relationship.
This discussion has been a little abstract, so let’s see an example
Example: Pricing a European Call Option
Let’s take the tradables table in (5.4) and use it to illustrate pricing. Assume that c is a European call
option on the stock S.
First, we designate the bond B and stock S as being the marketed assets, and c is the derivative that we
would like to price. Thus, the price APT implies that

B
S
c
¸
¸
λ
0
+

0
σS
σSc
S
¸
¸
λ
1
=

r
0
B
µS
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
¸
¸
. (5.8)
where the top two rows correspond to the marketed tradables. Then, we use the marketed tradables to
determine the market prices of risk. Solving these equations gives λ
0
= r
0
and λ
1
=
µ−r0
σ
.
Finally, we use these market prices of risk in the third equation for our derivative to obtain
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
= r
0
c +
µ −r
0
σ
σSc
S
(5.9)
Rearranging this gives
c
t
+r
0
Sc
S
+
1
2
σ
2
S
2
c
SS
= r
0
c (5.10)
which is the Black-Scholes partial differential equation for the price of an option. If we specify the boundary
condition for a European call option as
c(S, T) = (S −K)
+
, c(0, t) = 0 (5.11)
then this completely describes the price of the option.
A picture of the application of the Price APT is given in Figure 5.3.
5.5.3 Underdetermined and Overdetermined Systems
In the example above everything was perfect! I had two equations (one for the bond and one for the stock),
and two unknowns (the market price of time λ
0
and the market price of risk λ
1
) corresponding to the
marketed tradables. Thus, I could solve the equations for λ
0
and λ
1
. It was perfect!
Now, what if things aren’t so perfect. That is, what if the system of equations arising from the Price
APT for the marketed tradables is either underdetermined or overdetermined. Let use an example.
46 CHAPTER 5. CONSTRUCTING A FACTOR PRICING FRAMEWORK
Figure 5.3: A picture of the application of the Price APT.
Underdetermined and Incompleteness
Assume that our assets are given by
dB = r
0
Bdt (5.12)
dS = µSdt +σ
1
Sdz
1

2
Sdz
2
. (5.13)
In this case, the price APT becomes
¸
B 0 0
S σ
1
S σ
2
S

λ
0
λ
1
λ
2
¸
¸
=
¸
r
0
B
µS

(5.14)
And we have three unknowns (λ
0
, λ
1
, and λ
2
), but only two equations! Thus, we can’t uniquely solve for
the market prices of risk! (In this case, we can solve for λ
0
= r
0
, but not uniquely for λ
1
or λ
2
.)
What can we say in this situation and how should we think of this? Well, first, we can say that if any
solution exists (it doesn’t have to be unique, we just need for at least one solution to exist), then there is no
arbitrage. This is guaranteed by the APT equations.
Let’s assume that many solutions exists. For example in the above equations, there are multiple possible
values for λ
1
and λ
2
. Thus, there are many possible market prices of risk that satisfy the no arbitrage
condition. This just means that from the tradable assets in the market (B and S), we cannot uniquely infer
the market prices of risk for dz
1
and dz
2
. There are many possibilities, and all are arbitrage free.
The practical consequence of this is that if we are asked to price a new security that depends on dz
1
and/or dz
2
, we will not be able to assign it a unique absence of arbitrage price. This is because the APT
equation (in either return or price form) acts as a pricing equation. (This use will become clear in the
following chapters.) However, it only provides a unique price if we have unique values for the market prices
of risk. This situation is called an incomplete market.
Incomplete markets are common in practice, and you will see in subsequent chapters that in order to
price derivative securities in incomplete markets, we must select values for market prices of risk that are not
uniquely defined. Since market prices of risk relate risk to reward for various factors, selecting a value for
5.6. THREE STEP PROCEDURE 47
a market price of risk is essentially the same as specifying how investors in the market trade off risk and
return. Thus, in incomplete markets some specification of the risk preferences of investors is needed to assign
a unique price to derivative securities. Furthermore, this specification of risk preferences is captured by the
selection of the market price of risk.
The above discussion might be a little abstract at this point, but in subsequent chapters you might
want to refer back to it when faced with pricing of derivatives in incomplete markets (see for example,
jump-diffusion models or stochastic volaility).
Overdetermined and Calibration
Now let’s consider the opposite situation. That is, when the set of equations is overdetermined. For example,
let the tradable assets be
dB = r
0
Bdt (5.15)
dS
1
= µ
1
S
1
dt +σ
1
S
1
dz (5.16)
dS
2
= µ
2
S
2
dt +σ
2
S
2
dz. (5.17)
In this case, the price APT becomes

B 0
S
1
σ
1
S
S
2
σ
2
S
¸
¸
¸
λ
0
λ
1

=

r
0
B
µ
1
S
1
µ
2
S
2
¸
¸
(5.18)
In this case there are three equations and only two unknowns (λ
1
and λ
2
)! This system looks to be overde-
termined!
Now, we know from the price APT that for no arbitrage to exist there must exist a solution to this set
of equations. However, in general, for an overdetermined system of equations no solution will exist! What
does this mean?
Well, the first thing it means is that strictly speaking, there is an arbitrage opportunity! But, the way
this situation often plays out in practice is usually slightly different. In practice this situation often leads to
some sort of calibration procedure.
Instead of declaring that an arbitrage exists, a trader will often just assume that the models being used
for B, S
1
and S
2
are not perfect, and that is the reason that no solution exists. Thus, the trader will search
for the λ
1
and λ
2
that best fit the absence of arbitrage equations. They often call this process calibration,
and in practice it may be difficult to recognize directly as searching for best fit λ’s. (Watch for it in situations
such as term structure modeling where a single factor dz is used, but many tradables (bonds of different
maturities) exist, or when certain models are fit to volatility smiles and smirks.) Again, you might want to
return to this discussion after reading subsequent chapters.
5.6 Three Step Procedure
To summarize, let’s present a three step procedure to deriving a derivative pricing equation. The three steps
are:
1. Identify the tradable assets, underlying variables, and factors in a model. (See Figure 5.1.)
2. Write factor models (SDEs) for each tradable asset (this may involve Ito’s lemma), and construct a
tradables table. (See Figure 5.2.)
3. Apply the Price APT equation, first to the marketed tradables in order to solve for the market prices
of risk (calibration), and then to the derivative using those market prices of risk (this usually results
in a partial differential equation for the price). (See Figure 5.3.)
48 CHAPTER 5. CONSTRUCTING A FACTOR PRICING FRAMEWORK
In this book, I will consider the limited scope of just deriving partial differential equations for pricing, and I
will sometimes leave out the important step of actually solving the pde!! Furthermore, often many different
derivative securities satisfy the same basic pde and only differ due to their boundary condition. I will also
often sweep that under the rug, and merely note that a particular derivative security will correspond to the
solution of the pde with a particular boundary condition.
5.7 Summary
In this chapter, we have provided a three step procedure for deriving the pricing equation for a derivative
security based on the linear factor approach. This cookie cutter approach will allow us to derive many of
the partial differential (or difference/integral/etc.) equations that arise in derivative pricing theory. In the
next chapter we tackle examples in equity derivatives, and in the following chapter we address interest rate
derivatives. What you should take away is that simple arbitrage ideas that we derived in this chapter are
the underpinnings of derivative pricing theory.
5.8 Problems
Problem 5.8.1 (A Stock Paying Continuous Dividends)
Consider a stock S(t) following
dS = µSdt +σSdz (5.19)
that pays a continuous dividend at a rate of q. Also assume that a bond
dB = r
0
Bdt (5.20)
exists. If c(S, t) is a European call option on the stock, then identify the factors, underlying variables, and
create a tradables table.
Problem 5.8.2 (A Single Factor Short Rate Model)
Let r
0
(t) denote the short rate of interest, and assume that it follows
dr
0
= adt +bdz (5.21)
Assume that zero coupon bonds of maturity T are tradables and the price at time t is denoted by B(r, t|T).
Let these bonds be a function of the short rate and time t. Furthermore, assume that a money market account
exists that satisfies
dB
0
= r
0
(t)dB
0
dt (5.22)
In this model, then identify the factors, underlying variables, and create a tradables table.
Chapter 6
Application of the Factor Form:
Equity Derivatives
The factor approach to absence of arbitrage pricing is one of the quickest and most direct routes to deriving
pdes for derivatives. In this chapter we will see that it can be used to derive almost every Black-Scholes type
pde that occurs in derivative pricing.
6.1 Examples from Equity Derivatives
6.1.1 Black-Scholes
Black and Scholes started everything with this model [2]. The standard Black-Scholes set-up involves a bond
earning a risk free rate and a non-dividend paying stock that follows a GBM:
dB = r
0
Bdt (6.1)
dS = µSdt +σSdz. (6.2)
Furthermore, we consider a derivative on the stock. Generically we call this derivative c and assume that
it’s price process depends on the stock and time c(S, t) and is twice continuously differentiable in both its
arguments. By Ito’s lemma,
dc = (c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
)dt +σSc
S
dz. (6.3)
Therefore, the tradable assets are the stock S, bond B, and the derivative c. We can now move to Step 2
and construct a tradable table

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
µS
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
¸
¸
dt +

0
σS
σSc
S
¸
¸
dz. (6.4)
The tradable table contains all the information we need to apply the Price APT equation. Hence, this allows
us to move on to Step 3, which is to solve the Price APT equation Pλ
0
+Bλ
1
= A for absense of arbitrage
conditions.

B
S
c
¸
¸
λ
0
+

0
σS
σSc
S
¸
¸
λ
1
=

r
0
B
µS
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
¸
¸
. (6.5)
Solving for λ
0
and λ
1
using the first two equations gives:
λ
0
= r
0
λ
1
=
µ −r
0
σ
. (6.6)
49
50 CHAPTER 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES
Plugging λ
0
and λ
1
into the last equation yields
r
0
c +
µ −r
0
σ
σSc
S
= c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
. (6.7)
Finally, rearranging leads to the Black-Scholes equation:
c
t
+r
0
Sc
S
+
1
2
σ
2
S
2
c
SS
= r
0
c. (6.8)
European Call and Put Options
For a European call option, the boundary condition is that at expiration T, the option is worth c(S, T) =
max(S − K, 0) where K is the strike price. We also have the boundary conditions that c(0, t) = 0 for all t
and lim
S→∞
c(S, t) = ∞.
c(S, T) = max(S −K, 0) (6.9)
c(0, t) = 0 t ∈ [0, T] (6.10)
c(∞, t) = ∞ t ∈ [0, T] (6.11)
The solution is
d
1
=
ln(S/K) + (r
0
+
1
2
σ
2
)(T −t)
σ

T −t
(6.12)
d
2
= d
1
−σ

T −t (6.13)
c(S, t) = SN(d
1
) −Ke
−r0(T−t)
N(d
2
) (6.14)
A European put option is a derivative security p(S, t) with boundary conditions
p(S, T) = max(K −S, 0) (6.15)
p(0, t) = 0 Ke
−r0(T−t)
t ∈ [0, T] (6.16)
p(∞, t) = 0 t ∈ [0, T] (6.17)
The solution to the Black-Scholes equation under these boundary conditions is
d
1
=
ln(S/K) + (r
0
+
1
2
σ
2
)(T −t)
σ

T −t
(6.18)
d
2
= d
1
−σ

T −t (6.19)
p(S, t) = Ke
−r0(T−t)
N(−d
2
) −SN(−d
1
) (6.20)
6.1.2 Dividend Paying Stocks
Let’s assume that the stock is paying a continuous dividend at a rate of q. Then the stock and its dividend
stream is a tradable asset. That is, when we purchase the stock, we are also purchasing its dividend stream.
Hence we must consider them together as a tradable asset. Let’s assume the stock price follows
dS = µSdt +σSdz. (6.21)
What we purchase is a single share of this stock. Let N(t) denote the number of shares held of this stock at
time t. The assumption of a continuous dividend at a rate of q is equivalent to assuming that the number of
shares N(t) grows according to the equation
dN = qNdt. (6.22)
6.1. EXAMPLES FROM EQUITY DERIVATIVES 51
Then over time dt, the portfolio with value N(t)S(t) changes to
N(t)S(t) → (N(t) +dN)(S(t) +dS) (6.23)
= N(t)S(t) +dNS(t) +N(t)dS +dSdN (6.24)
= N(t)S(t) +qN(t)S(t)dt +µN(t)S(t)dt +σN(t)S(t)dz +o(dt). (6.25)
If we denote the value of the share with its dividend stream by v(t) = N(t)S(t) then we have
dv = v(t +dt) −v(t) = (µ +q)v(t)dt +σv(t)dz. (6.26)
Hence, we consider v(t) the tradable.
Finally, we consider the option. Now, the payoff of the option depends on the price of the stock alone,
and does not depend on the dividend stream. Therefore, we assume c = c(S, t) and apply Ito’s lemma to c
to obtain
dc = (c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
)dt +σSc
S
dz. (6.27)
The next step is to write the tradable table

B
v
c
¸
¸
d

B
v
c
¸
¸
=

r
0
B
(µ +q)v
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
¸
¸
dt +

0
σv
σSc
S
¸
¸
dz. (6.28)
Note that the stock price alone S(t) does not appear in the tradable table since it is not tradable. Only
tradable quantities appear in the tradables table, and only those quantities need to satisfy the absence of
arbitrage conditions.
The final step is to solve the Price APT equation Pλ
0
+Bλ
1
= A,

B
v
c
¸
¸
λ
0
+

0
σv
σSc
S
¸
¸
λ
1
=

r
0
B
µv
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
¸
¸
. (6.29)
Solving for λ
0
and λ
1
gives:
λ
0
= r
0
λ
1
=
µ +q −r
0
σ
, (6.30)
and plugging λ
0
and λ
1
into the last equation gives
r
0
c +
µ +q −r
0
σ
σSc
S
= c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
. (6.31)
Finally, rearranging leads to the Black-Scholes equation:
c
t
+ (r
0
−q)Sc
S
+
1
2
σ
2
S
2
c
SS
= r
0
c. (6.32)
What does this apply to?
At first thought, a continuous model for a dividend does not seem too realistic. However, a moment of
thought more, we realize that it is a decent approximation for a number of financial situations. For instance,
a stock index with many stock that pay dividends at different times can be approximated as a continuous
dividend. So can a commodity with a convenience yield. Moreover, foreign currencies that are invested in a
money market account are essentially a security that earns a continuous dividend. So, the point is, don’t let
the notation of calling S a ”stock” limit your thinking about how these models can be applied.
52 CHAPTER 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES
European Call Option
Once again, we can consider the value of a European call option, but this time on a stock that pays a
continuous dividend. The solution is
d
1
=
ln(S/K) + (r
0
−q +
1
2
σ
2
)(T −t)
σ

T −t
(6.33)
d
2
= d
1
−σ

T −t (6.34)
c(S, t) = Se
−q(T−t)
N(d
1
) −Ke
−r0(T−t)
N(d
2
) (6.35)
Note that this is very similar to the formula for a European call option on a non-dividend paying stock, except
that q shows up in a couple of places. This is too be expected, since (6.42) differs from the non-dividend
Black-Scholes equation only slightly.
6.1.3 Cash Dividends
Most individual stocks pay a prespecified dividend at a prespecified time. We often call this either a cash or
lump dividend. To compute the equation satisfied by an option on a stock that pays a cash dividend prior
to expiration, we can once again use our three step procedure.
Of course, the bond is a tradable. Now, we can purchase a share of the stock, and with this we will get
the stock price plus the dividend. This entire stream together it what is tradable.
To model this, we consider that the value corresponding to a single share is continuous and follows a
geometric Brownian motion. Call this value v(t), where it satisfies
dv = µvdt +σvdz. (6.36)
Now, we assume that the stock pays a dividend at the time τ in the amount of D. Therefore, we model the
stock price as dropping by D exactly at the time τ. To model this drop, we will use dirac delta notation
and write it as
dS = (µS −Dδ(t −τ))dt +σdz (6.37)
where δ(t − τ) is a dirac delta function at time τ. This notation is just to indicate that the price drops by
exactly D at time τ.
Now, we assume that c(S, t) is a derivative security, and we apply Ito’s lemma to obtain
dc = (c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
+ (c(S

−D, t) −c(S

, t))δ(t −τ))dt +σSc
S
dz (6.38)
I have not described how to apply Ito’s lemma in this situation before. However, you may recognize that
this situation is very similar to a process driven by a Poisson process, since they have discrete jumps. In this
case, it is even simpler, since we know exactly when the jump will occur. The above equation just indicates
that we use Ito’s lemma for Brownian motion up to, and after the jump time τ. However, at time τ the
jump occurs, which causes c to drop by exactly D. Once again, the delta function δ(t −τ) is really just used
to indicate that a jump occurs at time τ.
Therefore, we have identified the tradables B, v, and c, and now we can write the tradables table.

B
v
c
¸
¸
d

B
v
c
¸
¸
=

r
0
B
µv
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
+ (c(S

−D, t) −c(S

, t))δ(t −τ)
¸
¸
dt +

0
σv
σSc
S
¸
¸
dz
The final step is to solve the Price APT equation

B
v
c
¸
¸
λ
0
+

0
σv
σSc
S
¸
¸
λ
1
=

r
0
B
µv
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
+ (c(S

−D, t) −c(S

, t))δ(t −τ)
¸
¸
(6.39)
6.1. EXAMPLES FROM EQUITY DERIVATIVES 53
Solving for λ
0
and λ
1
gives:
λ
0
= r
0
λ
1
=
µ −r
0
σ
(6.40)
Plugging λ
0
and λ
1
into the last equation yields
r
0
c +
µ −r
0
σ
σSc
S
= c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
+ (c(S

−D, t) −c(S

, t))δ(t −τ) (6.41)
Finally, rearranging leads to the Black-Scholes equation:
c
t
+r
0
Sc
S
+
1
2
σ
2
S
2
c
SS
+ (c(S

−D, t) −c(S

, t))δ(t −τ) = r
0
c. (6.42)
6.1.4 Poisson Processes
This was done by Cox and Ross [5]. This set-up involves a bond earning a risk free rate and a non-dividend
paying stock that follows a geometric Poisson motion (GPM):
dB = r
0
Bdt (6.43)
dS = µS

dt + (k −1)S

dπ(ν) (6.44)
where ν is the intensity of the Poisson process π(t; ν). Furthermore, we consider a derivative on the stock.
Generically we call this derivative c and assume that its price process depends on the stock and time c(S, t)
and is continuously differentiable in both its arguments. By Ito’s lemma,
dc = (c
t
+µSc
S
)dt + (c(kS

) −c(S

))dπ(ν). (6.45)
This is a case where the random factor does not have zero mean. I would like to write my factor equations
such that the factors are pure risk and don’t have any mean drift. Hence, I will compensate the factor in
order to give it zero drift. In this case, my tradables are
dB = r
0
Bdt (6.46)
dS = (µS +ν(k −1)S)dt + (k −1)S(dπ(ν) −νdt) (6.47)
dc = (c
t
+µSc
S
+ν(c(kS

) −c(S

)))dt + (c(kS

) −c(S

))(dπ(ν) −νdt) (6.48)
We can now construct a tradables table

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
µS +ν(k −1)S
c
t
+µSc
S
+ν(c(kS

) −c(S

))
¸
¸
dt +

0
(k −1)S
c(kS

) −c(S

)
¸
¸
(dπ(ν) −νdt)
This allows us to move on to Step 3, which is to solve the Price APT equation Pλ
0
+Bλ
1
= A for absence
of arbitrage

B
S
c
¸
¸
λ
0
+

0
(k −1)S
c(kS

) −c(S

)
¸
¸
λ
1
=

r
0
B
µS +ν(k −1)S
c
t
+µSc
S
+ν(c(kS

) −c(S

))
¸
¸
.
Solving for λ
0
and λ
1
gives:
λ
0
= r
0
λ
1
=
µ −r
0
k −1
+ν. (6.49)
Plugging λ
0
and λ
1
into the last equation yields
r
0
c +

µ −r
0
k −1

(c(kS

) −c(S

)) = c
t
+µSc
S
+ν(c(kS

) −c(S

)) (6.50)
Finally, rearranging leads to the equation:
(µ −r
0
) (c(kS

) −c(S

)) = (k −1) (c
t
+µSc
S
−r
0
c) . (6.51)
54 CHAPTER 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES
European Call Option
One can actually find a closed form solution for European call and put options in this model. I will give the
solution for a call option with strike K and expiration T:
c(S, t) = SΨ(x, y) −Ke
−r0(T−t)
Ψ(x, y/k) (6.52)
where
Ψ(α, β) =

¸
i=α
e
−β
β
i
i!
, y =
(r
0
−µ)(T −t)k
k −1
(6.53)
and x is the smallest non-negative integer greater than
ln(K/S)−µ(T−t)
ln(k)
.
Note that this solution has a structure that is very similar to the Black-Scholes fomula. In fact, one can
interpret it as the Black-Scholes formula, but with a Poisson random variable replacing the Gaussian random
variable.
6.1.5 Options on Futures
This was essentially done by Black in [1]. Let’s derive the pde satisfied by an option on a futures contract.
Assume there exists a bond and a futures contract with futures price f given as
dB = r
0
Bdt (6.54)
df = µfdt +σfdz. (6.55)
Furthermore, we consider a derivative on the futures price. Generically we call this derivative c and assume
that it’s price process depends on the futures price and time c(f, t) and is twice continuously differentiable
in both its arguments. By Ito’s lemma,
dc = (c
t
+µfc
f
+
1
2
σ
2
f
2
c
ff
)dt +σfc
f
dz. (6.56)
We can now complete Step 2 and construct a tradables table

B
0
c
¸
¸
d

B
f
c
¸
¸
=

r
0
B
µf
c
t
+µfc
f
+
1
2
σ
2
f
2
c
ff
¸
¸
dt +

0
σf
σfc
f
¸
¸
dz. (6.57)
Recall that the futures contract was the special case that motivated us to consider the price approach
to absence of arbitrage, rather than working with returns. The key point was that the mark-to-market
mechanism always sets the price of a futures contract to zero while the change in value of the contract over
period dt is given by the change in the futures price df. This corresponds to the tradable table we have
written above.
This allows us to move on to Step 3, which is to solve the Price APT equation Pλ
0
+Bλ
1
= A for absense
of arbitrage.

B
0
c
¸
¸
λ
0
+

0
σf
σfc
f
¸
¸
λ
1
=

r
0
B
µf
c
t
+µfc
f
+
1
2
σ
2
f
2
c
ff
¸
¸
(6.58)
Solving for λ
0
and λ
1
gives:
λ
0
= r
0
λ
1
=
µ
σ
. (6.59)
Plugging λ
0
and λ
1
into the last equation yields
r
0
c +
µ
σ
σfc
f
= c
t
+µfc
f
+
1
2
σ
2
f
2
c
ff
. (6.60)
Finally, rearranging leads to the partial differential equation:
c
t
+
1
2
σ
2
f
2
c
ff
= r
0
c. (6.61)
6.1. EXAMPLES FROM EQUITY DERIVATIVES 55
European Call Option
Note that the Black-Scholes equation in this case (6.61), looks just like the Black-Scholes equation on a stock
paying a continuous dividend, however the continuous dividend rate is q = r. Therefore, we can just plug
into that formula to obtain the price of a European call option. The solution is
d
1
=
ln(f/K) + (
1
2
σ
2
)(T −t)
σ

T −t
(6.62)
d
2
= d
1
−σ

T −t (6.63)
c(f, t) = fe
−r0(T−t)
N(d
1
) −Ke
−r0(T−t)
N(d
2
). (6.64)
6.1.6 Jump diffusion
A jump diffusion model was first solved by Merton [11]. This model is nice because it is related to many
other models in equity and interest rate derivatives. The model includes a risk free bond and an underlying
asset that has a diffusion portion and a lognormal jump portion. This model has a closed form solution for
the derivative price which Merton computed in his original paper [11].
We will also find that this model creates a problem for our factor approach. Merton originally solved this
problem using a similar technique, and we will bypass the problem in the same manner that Merton did.
Let’s get started. Here are the basic assets
dB = r
0
Bdt (6.65)
dS = (µ +αE[Y −1])Sdt +σSdz +S

((Y −1)dπ(α) −αE[Y −1]dt) (6.66)
where the jump portion of the stock has been compensated. A derivative on the stock c(S, t) is a function
of S and t. By Ito’s lemma we have
dc = Lcdt +σSc
S
dz +

(c(Y S

) −c(S

))dπ −αE[(c(Y S

) −c(S

))]dt

(6.67)
where
Lc = c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
+αE[(c(Y S

) −c(S

))] (6.68)
Now we come to the point that we need to write a tradables table. This is where we run into a problem.
The problem is how to identify factors. The randomness associated with the jump term does not enter in
the same way to S and c. We would like to be able to write down a linear factor model in the factors dz
and Y dπ or a compensated version of of Y dπ. However, in this case that is not possible unless we consider
c(Y S

) − c(S

)dπ a new factor. However, since this risk is driven by the same Poisson process and jump
size Y , we would rather not do this. Yet, at this point we have no choice.
So, let’s proceed by considering ((c(Y S

) −c(S

))dπ −αE[(c(Y S

) −c(S

))]dt) and (Y − 1)dπ(α) −
αE[Y −1]dt as two different factors. For notational convenience, let’s call them

1
= (Y −1)dπ(α) −αE[Y −1]dt (6.69)

2
=

(c(Y S

) −c(S

))dπ −αE[(c(Y S

) −c(S

))]dt

(6.70)
Then our tradables table is

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
(µ +αE[Y −1])S
Lc
¸
¸
dt +

0 0 0
σS S 0
σSc
S
0 1
¸
¸

dz

1

2
¸
¸
(6.71)
Finally, we would solve the Price APT equations

B
S
c
¸
¸
λ
0
+

0 0 0
σS S 0
σSc
S
0 1
¸
¸

λ
1
λ
2
λ
3
¸
¸
=

r
0
B
(µ +αE[Y −1])S
Lc
¸
¸
(6.72)
56 CHAPTER 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES
Now, we can write out the full pde which will have a number of unknown market prices of risk. This is
fairly messy and leaves a lot of degrees of freedom. Merton doesn’t do this. Instead he make the assumption
that all jump risk is diversifiable. That is, the market price of risk of any risk associated with the jump term
is zero! This is the same as setting λ
2
= λ
3
= 0. This is a strong assumption! But let’s follow Merton and
see where this leads us.
With λ
2
= λ
3
= 0, the Price APT equations Pλ
0
+Bλ = A become

B
S
c
¸
¸
λ
0
+

0
σS
σSc
S
¸
¸

λ
1

=

r
0
B
(µ +αE[Y −1])S
Lc
¸
¸
. (6.73)
Now we can solve for the market prices of risk as,
λ
0
= r
0
, λ
1
=
µ +αE[Y −1]
σ
, (6.74)
and the final equation becomes
r
0
c +

µ +αE[Y −1] −r
0
σ

σSc
S
= Lc (6.75)
which can be rewritten as
c
t
+ (r
0
−αE[Y −1])Sc
S
+
1
2
σ
2
S
2
c
SS
= r
0
c −αE[(c(Y S

) −c(S

))]. (6.76)
Bankruptcy
Let’s consider a special case of complete bankruptcy. That is, Y = 0. Then the above equation becomes
c
t
+ (r
0
+α)Sc
S
+
1
2
σ
2
S
2
c
SS
= (r
0
+α)c. (6.77)
This looks like standard Black-Scholes but the interest rate has been increased by the default probability!
We will see that this same relationship will also appear in defaultable bonds. In fact, this model is really
the prototype for defaultable bonds. Of course, we can give a closed form solution in this case based on the
Black-Scholes formula.
Note the following counterintuitive observation. In the Black-Scholes formula, the value of a European
call option increases with the risk free rate. This means that according to our model above, if the rate
of bankruptcy increases, then the value of call option will actually increase! You should think about this
carefully to understand why that is true...
Lognormal Jumps!
When Y the jump size is lognormal, then conditional on the number of jumps that have occurred before
expiration, stock distribution at expiration is lognormal, and there is a closed form solution to the pde for
European call and put options. For a European call option with strike K and expiration T, it is given by
c(S, t) =

¸
n=0
¸
e
−λ

(T−t)


(T −t))
n
n!
¸
c
BS

S, T −t, K, σ
2
+

2
T −t
, r
0
−λk +

T −t

(6.78)
where c
BS
(S, T, K, σ, r
0
) is the Black-Scholes formula for a European call option with strike K and expiration
T on a non-dividend paying stock with current price S, volatility σ, and with risk free rate r
0
. We also have
that k = E[Y −1], λ

= λ(1 +k), and γ = ln(1 +k). This formula can be found in Merton’s work [11].
Note that it is basically a combination of the Black-Scholes formula and the solution under Poisson
dynamics. The key is that under this jump diffusion model, conditional on the number of jumps, the price
6.1. EXAMPLES FROM EQUITY DERIVATIVES 57
distribution at expiration is log-normal, indicating that the solution should look like Black-Scholes. The
only question is how many jumps have occurred. Therefore, the solution is basically that conditioned on
the number of jumps that have occurred, the answer is Black-Scholes. Hence, for each possible number of
jumps, we have a Black-Scholes formula, then we need to weight them by the probability of that number of
jumps, which is Poisson. Simple!
6.1.7 Exchange one asset for another
Margrabe’s [10] exchange one asset for another is one of my favorite derivatives. Why? because many other
derivatives can be thought of as exchanging two different assets. For instance, can a vanilla call option be
thought of as exchanging one asset for another? What are the two assets being exchanged?
Anyway, in this case, tradable assets will be called the bond B and two other assets S
1
and S
2
. Their
dynamics are given by:
dB = r
0
Bdt (6.79)
dS
1
= µ
1
S
1
dt +σ
1
S
1
dz
1
(6.80)
dS
2
= µ
2
S
2
dt +σ
2
S
2
dz
2
(6.81)
dc = L
1
cdt + +σS
1
c
S1
dz
1
+σS
2
c
S2
dz
2
(6.82)
where
L
1
c = (c
t

1
S
1
c
S1

2
S
2
c
S2
+
1
2
σ
2
1
S
2
1
c
S1S1
+
1
2
σ
2
2
S
2
2
c
S2S2
+ρσ
1
σ
2
S
1
S
2
c
S1S2
) (6.83)
and ρ is the correlation coefficient between z
1
and z
2
. Thus, the tradable table is

B
S
1
S
2
c
¸
¸
¸
¸
d

B
S
1
S
2
c
¸
¸
¸
¸
=

r
0
B
µ
1
S
1
µ
2
S
2
Lc
¸
¸
¸
¸
dt +

0 0
σ
1
S
1
0
0 σ
2
S
2
σ
1
S
1
c
S1
σ
2
S
2
c
S2
¸
¸
¸
¸
¸
dz
1
dz
2

. (6.84)
Finally, we solve the Price APT equations

B
S
1
S
2
c
¸
¸
¸
¸
λ
0
+

0 0
σ
1
S
1
0
0 σ
2
S
2
σ
1
S
1
c
S1
σ
2
S
2
c
S2
¸
¸
¸
¸
¸
λ
1
λ
2

=

r
0
B
µ
1
S
1
µ
2
S
2
Lc
¸
¸
¸
¸
. (6.85)
In this case we have four equations and only three unknowns. Let’s use the first three equations to solve
for λ
0
, λ
1
and λ
2
as
λ
0
= r
0
λ
1
=
µ
1
−r
0
σ
1
λ
2
=
µ
2
−r
0
σ
2
. (6.86)
If we plug these into the final equation, we obtain
Lc = r
0
c +
µ
1
−r
0
σ
1
σ
1
S
1
c
S1
+
µ
1
−r
0
σ
1
σ
1
S
1
c
S1
(6.87)
which upon rearrangement becomes
c
t
+r
0
S
1
c
s1
+r
0
S
2
c
s2
+
1
2
σ
2
1
S
2
1
c
s1s1
+
1
2
σ
2
2
S
2
2
c
s2s2
+ρσ
1
σ
2
S
1
S
2
c
s1s2
= r
0
c. (6.88)
58 CHAPTER 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES
Closed form solution
There is a closed form solution for a European exchange one asset for another. Assume that you have the
option to exchange asset S
1
for asset S
2
at time T. Hence, the boundary condition is
c(S
1
, S
2
, T) = max(S
2
−S
1
, 0), c(0, S
2
, t) = S
2
, c(S
1
, 0, t) = 0. (6.89)
The closed form solution for this option is
c(S
1
, S
2
, t) = S
2
N(d
1
) −S
1
N(d
2
) (6.90)
where
d
1
=
ln(S
2
/S
1
) +
1
2
σ
2
(T −t)
σ

T −t
(6.91)
d
2
= d
1
−σ

T −t (6.92)
σ =

σ
2
1

2
2
−2ρσ
1
σ
2
. (6.93)
Note that this solution looks very much like Black-Scholes. Here is some intuition into why. Let’s look at
the payoff
c(S
1
, S
2
, T) = max(S
2
−S
1
, 0) = S
1
max(
S
2
S
1
−1, 0).
Now, the portion max(
S2
S1
−1, 0) looks like the payoff of a call option with strike 1 on the asset
S2
S1
! In fact,
dividing S
2
by S
1
is essentially changing units in order to value S
2
in units of S
1
. Therefore, in units of S
1
,
this is just a call option on S
2
with strike 1! The multiplication on the left by S
1
just converts the call option
back to units of dollars. Therefore, we shouldn’t be surprised that the solution looks like Black-Scholes,
because this is really just a call option in a different set of units.
When we change units by denominating everything in terms of another asset (such as S
1
in this case),
we call that a change of numeraire, and we call the asset S
1
the numeraire asset. Needless to say, some
problems (such as this one) are easier to solve in a convenient set of units.
6.1.8 Stochastic volatility
First, we can list the relevant equations
dB = r
0
Bdt (6.94)
dS = µSdt +

vSdz
1
(6.95)
dv = adt +bdz
2
(6.96)
and we assume that z
1
and z
2
are correlated E[dz
1
dz
2
] = ρdt.
Our derivative can depend on S, t, and v. Hence, we write c(S, v, t). (What if I didn’t assume the
derivative was a function of v? This would have been a bad assumption since I know in the Black-Scholes
case that c is a function of the volatility. Would I end up getting the wrong answer?)
By Ito’s lemma we have:
dc = Lcdt +

vSc
S
dz
1
+bc
v
dz
2
(6.97)
where
Lc = (c
t
+µSc
S
+ac
v
+
1
2
vS
2
c
SS
+
1
2
b
2
c
vv
+ρb

vSc
Sv
) (6.98)
In this case the tradables are
dB = r
0
Bdt (6.99)
dS = µSdt +

vSdz
1
(6.100)
dc = Lcdt +

vSc
S
dz
1
+bc
v
dz
2
(6.101)
6.2. PROBLEMS 59
So the tradable table is

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
µS
Lc
¸
¸
dt +

0 0

vS 0

vSc
S
bc
v
¸
¸
¸
dz
1
dz
2

. (6.102)
Finally, we solve the Price APT equations

B
S
c
¸
¸
λ
0
+

0 0

vS 0

vSc
S
bc
v
¸
¸
¸
λ
1
λ
2

=

r
0
B
µS
Lc
¸
¸
. (6.103)
Solving for the market prices of risks λ
0
and λ
1
gives
λ
0
= r
0
λ
1
=
µ −r
0

v
. (6.104)
Note that we leave λ
2
as an unknown. Plugging these into the final equations leads to
c
t
+r
0
Sc
S
+ (a −λ
2
b)c
v
+
1
2
vS
2
c
SS
+
1
2
b
2
c
vv
+ρb

vSc
Sv
= r
0
c (6.105)
Under specific choices of a and b, for a European call option, this pde has a fairly convenient solution via
transform methods. I won’t cover this in detail here. See Heston [9] if interested.
6.2 Problems
Problem 6.2.1 Show that the Black-Scholes formula (6.14) is a special case of exchange one asset for
another where one asset is the stock S(t) and the other is the bond B(t). In particular, show that the
exchange one asset for another formula (6.90) reduces to the Black-Scholes formula (6.14) in this case.
Problem 6.2.2 (The power of linearity (Breeden and Litzenberger)) We will use linearity to derive the
formula for a European digital option in terms of a European call option price. A digital option is an option
that pays off 1 if the underlying stock ends up above the strike price K, and pays nothing if it ends up below
the strike price.
(a) Let T be the expiration date for the digital option. Draw a picture of the payoff as a function of S
T
.
(b) Assume that you know the price of European call options for every strike K for the expiration date
T (i.e. c(S, K, t)). Using only this information, derive the price of a digital option with strike K in
terms of c(S, K, t). (Hint: think of how you can construct the payoff of a digital option by buying and
selling call options.)
(c) Taking the above argument one step further, derive the ”price” of a security whose payoff is a dirac
delta function at K at expiration T.
(d) Use the result of (c) to derive a general pricing formula for an arbitrary payoff at time T. Note that if
you have made it this far, you have ”derived” the risk neutral pricing formula in terms of c(S, K, t).
(If you plug in the Black-Scholes formula for c(S, K, t) then you have the standard risk neutral pricing
formula when the underlying asset follows a geometric Brownian motion.)
(e) As one final task, price a security whose payoff is (S
T
−K)
2
for S
T
≥ K and 0 for S
T
< K.
(Here is a big hint if you are having trouble with this problem. We can think of the payoff of a European
call option as a ramp function. A digital option looks like a step function, and finally we price a dirac delta
function. What is the relationship between a ramp, step and delta function?)
60 CHAPTER 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES
Problem 6.2.3 All about Put-Call parity and Early Exercise.
(a) Derive put-call parity for European call and put options on a non-dividend paying stock.
(b) Early exercise is not optimal for a standard American call option on a non-dividend paying stock.
Derive this.
(c) Assume the payoff of a derivative security on a non-dividend paying underlying stock is a convex
function that is non-positive when the stock is zero. Prove that if this is an American option, it is
never optimal to exercise early.
(d) Consider the European option to exchange one asset, S
2
, for another S
1
(assume they are non-dividend
paying) at expiration T. That is, if you currently hold S
2
, this option would give you the right to
exchange it for S
1
at time T. This is a derivative security with payoff c(S
1
, S
2
, T) = max[S
1
−S
2
, 0].
Derive a parity relating S
1
, S
2
and the options to exchange S
1
for S
2
and vice-versa.
(e) (Margrabe) Consider an American option to exchange one asset for another (non-dividend paying
again). Is it ever optimal to exercise this early?
(f ) Merton showed that it can be optimal to exercise a put option early, even on a non-dividend paying
stock. However, we can think of a European put option as exchanging a stock for a bond, in which case,
the American counterpart would never be exercised early according to Margrabe. Is there a contradiction
here?
Problem 6.2.4 (Exchange one asset for another) In this problem you will derive the formula for an option
to exhange one asset for another by reducing the pde to a standard Black-Scholes pde for a call option on
geometric Brownian motion.
(a) Let S
1
and S
2
be two assets whose dynamics are given by
dS
1
= µ
1
S
1
dt +σ
1
S
1
dz
1
(6.106)
dS
2
= µ
2
S
2
dt +σ
2
S
2
dz
2
(6.107)
where E[dz
1
dz
2
] = ρdt and assume that a risk free asset exists with constant interest rate r. Write down
the pde for an option to exchange S
2
for S
1
at expiration T. (Hence, the payoff is max(S
1
−S
2
, 0).)
(b) Consider the change of variable v = S
1
/S
2
and assume that the solution of the above pde is of the form
c(S
1
, S
2
, t) = S
2
f(v, t). Using these substitutions, write the pde from (a) in terms of S
2
, t, f, and v.
What equation must f(v, t) satisfy? What is the appropriate boundary condition for a European option
to exchange S
2
for S
1
in terms of the new variables.
(c) Using the Black-Scholes formula, write down a formula for the value of an option to exchange S
1
for
S
2
.
Problem 6.2.5 Consider a European call option on a non-dividend paying stock with stochastic volatility.
But, this time we model the instantaneous variance with a Poisson process. The idea is that most of the time
the instantaneous variance is σ
2
l
, but at random times the market goes wild and the instantaneous variance
jumps by an amount b. After the jump, the instantaneous variance exponentially decays back to its normal
level σ
l
. First write down the relevant dynamics for this problem, then derive a pde for the price of the
option. Again, this pde can be in terms of a market price of risk.
(Hint: your dynamics should look like:
dS = µSdt +

vSdz
dv = a(σ
2
l
−v)dt +bdπ
where π is a Poisson process with intensity α.)
6.2. PROBLEMS 61
Problem 6.2.6 (Matlab Exercise) This exercise will introduce you to the implied volatility curve. If c
m
is
the market value of a call option with strike K, expiration T, and if c
BS
(S, K, T, r
0
, σ) (assuming the stock is
non-dividend paying) is the Black-Scholes formula for a European call option. Then the value of the volatility
parameter σ
impl
that satisfies
c
m
= c
BS
(S, K, T, r
0
, σ
impl
) (6.108)
is known as the implied volatility. In this exercise, you will generate prices under Merton’s jump-diffusion
model, and compute implied volatility curves.
a. Use an initial stock price of S(0) = 1, expiration of T = 0.3, and a risk free rate of r = 0.05. For
a range of strike prices from K = [0.8, 1.2], first compute the Black-Scholes price of options using
σ = 0.3, then assume that they represent market prices and plot the resulting implied volatility curve
as a function of K.
b. This time, use Merton’s jump-diffusion model to to generate the market prices. Use the same parameter
values as in part (a) (i.e. S(0) = 1, T = 0.3, r = 0.05, and σ = 0.3), and also jump intensity of λ = 2,
jump mean of ν
J
= 0 and jump standard deviation of σ
J
= 0.1. Once again plot the resulting implied
volatility curve. You should see a slight implied volatility ”smile”!
Problem 6.2.7 (American Options) Use the results of Chapter 4, Problem 3 to derive the pde conditions
followed by an American call or put option where the underlying stock (non-dividend paying) and bond follow
dS = µSdt +σSdz
dB = r
0
Bdt.
62 CHAPTER 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES
Chapter 7
Application of the Factor Form:
Interest Rate and Credit Derivatives
In this chapter, we apply the factor approach to interest rate and credit derivatives. Again, the emphasis is
showing that the pdes describing derivative pricing can all be easily derived from the simple factor approach
equations.
Before getting started, let’s make a few comments about interest rate modeling and derivatives. For any
derivative pricing problem, the first challenge before being able to price a derivative is the calibration phase
as in Figure 5.3 of Chapter 5. For many equity derivatives, the calibration phase does not play prominently
into the analysis. In fact, in many equity derivative models the market is either complete in which case the
calibration phase of determining λ is simple, or the market is incomplete in which case the APT equations
are underdetermined and one is left with a degree of freedom in choosing λ.
Interest rate and term structure models tend to be the opposite. That is, we may use a single factor, but
have many, many marketed tradables. This makes the APT equations overdetermined! Thus, the calibration
phase is in determining λ values that best fit all the marketed tradables (In theory if there isn’t a perfect
fit, then an arbitrage is available. However in practice we simply recognize that our model is too simple
and try to find a best-fit λ). Once calibration is done, then pricing a derivative just proceeds by solving the
appropriate pde with boundary conditions using the calibrated λ. Because calibration is so important in
interest rate and term structure models, in what follows, we will often bring the models up to the point of
calibration, but not consider specific derivatives after that point.
Beyond this, the truth is that some of these models (such as HJM) are better suited for the risk neutral
approach to derivative pricing (A subject that is touched upon in Chapter 9) simply because the pdes that
we obtain are often too large and difficult to solve in any reasonable manner. Nevertheless, it is extremely
instructive to see that they can be understood via the factor approach. Since I have mentioned risk neutral
pricing, I should also mention that ”calibration” in risk neutral pricing often looks different from what I
have called the calibration phase (which is just determining the market prices of risk from the marketed
tradables). However, they are really the same thing, just described using a different ”language”. Hopefully,
at the end of your studies of derivative pricing you will be able to ”translate” between them.
Okay, let’s get to pricing...
7.1 Notation and the Money Market Account
In dealing with bonds and interest rate derivatives, we will need to establish some notation. Let’s start with
the short rate process. The short rate r
0
(t) is the interest rate earned from time t to time t + dt quoted
using continuous compounding. (Note that the notation is similar to the constant risk free rate r
0
used in
the previous chapter. This is because the short rate plays the same crucial role as the constant risk free rate
in that it defines the market price of time, λ
0
.)
63
64CHAPTER 7. APPLICATIONOF THE FACTOR FORM:INTEREST RATE ANDCREDIT DERIVATIVES
On a plot of the term structure, the short rate is where is spot rate curve intersects the y-axis as in
Figure 7.1. The short rate process is important because it can be used to drive the entire spot rate curve.
Figure 7.1: The Short Rate Process
Furthermore, the short rate r
0
(t) describes the instantaneous return on the money market account. That
is, we define the money market account B
0
(t) as the value of an account that is continuously rolled over at
the instantaneous short rate. That is, you invest your money at the rate r
0
(t) over the next dt, then you
reinvest that amount over the next dt at the rate r
0
(t + dt), and continue this. Hence, the money market
account B
0
(t) follows the dynamics
dB
0
(t) = r
0
(t)B
0
(t)dt (7.1)
The money market account often plays a special role in interest rate derivatives because its dynamics are
not explicitly driven by a random factor. Note that this is the case even though r
0
(t) itself can be random
and follow a stochastic differential equation of its own. Pay careful attention to the role that the money
market account plays in what follows.
7.2 Interest Rate Derivatives
7.2.1 Single Factor Short Rate Models
The simpliest interest rate derivative model has a single underlying variable: the short rate. Furthermore,
this variable is driven by a single factor. Hence, these models are typically called single factor short rate
models. Vasicek [15] was the first to recognize that pricing with absence of arbitrage was possible by modeling
the instantaneous short rate. Hence, we will model this short rate variable as
dr
0
= adt +bdz (7.2)
where the time dependence is supressed in r
0
= r
0
(t), and a = a(r
0
, t), b = b(r
0
, t) can be functions of r
0
and
t. When convenient, we will suppress these arguments, so don’t always assume that a variable is a constant
if no arguments are explicitly listed.
The tradables are a money market account, which we denote by B
0
and zero coupon bonds with face
value of $1 of varying maturity that we denote by B(t|T) where t is the current time and T is the maturity
date. This is pictured in Figure 7.2. We assume that the zero coupon bonds are functions of the short rate,
B(r
0
, t|T). Then suppressing arguments, we can write
dB
0
= r
0
B
0
dt (7.3)
dB(T) = (B
t
(T) +aB
r
(T) +
1
2
b
2
B
rr
(T))dt +bB
r
(T)dz (7.4)
7.2. INTEREST RATE DERIVATIVES 65
Figure 7.2: Notation for Zero Coupon Bond Prices
where Ito’s lemma was used to derive the equation for dB(T), and B
r
, B
rr
, represent the first and second
partial derivatives with respect to the short rate r
0
, respectively. In particular, not that for convenience
when using this partial derivative notation we supress the subscript r
0
and write B
r
= B
r0
.
Now let’s write down the tradable table:
¸
B
0
B(T)

d
¸
B
0
B(T)

=
¸
r
0
B
0
(B
t
(T) +aB
r
(T) +
1
2
b
2
B
rr
(T))

dt +
¸
0
bB
r
(T)

dz (7.5)
Finally, we solve the Price APT equations
¸
B
0
B(T)

λ
0
+
¸
0
bB
r
(T)

λ
1
=
¸
r
0
B
0
(B
t
(T) +aB
r
(T) +
1
2
b
2
B
rr
(T))

(7.6)
The first equation gives λ
0
= r
0
which is the random short rate. Then the second equation gives
(B
t
(T) + (a −λ
1
b)B
r
(T) +
1
2
b
2
B
rr
(T)) = r
0
B(T) (7.7)
The boundary condition is of course that B(T|T) = 1. This equation must hold for zero coupon bonds of
any maturity. Note that it is in terms of a market price of risk. In fact, since in general we have many bonds,
any one of them should allow us to solve for λ
1
. In practice, different bonds will often give different values
of λ
1
, indicating that the model is not exactly correct.
When one tries to determine a single best fit λ
1
from the bond data, we are treating all the bonds as
being marketed tradables, and thus this is interpreted as a calibration phase. After this calibration phase,
one could then use this model to price other interest rate derivatives such as caps, floors, bond options, etc.
7.2.2 Multi-Factor Short Rate Models
The single factor short rate models are usually not good enough to describe the term structure well. So,
instead of using a single factor model, we can use a multifactor model as follows.
Let X be a vector in R
n
of underlying variables affecting the term structure. We assume that these
variables follow a stochastic differential equation model
dX = f(X, t)dt +g(X, t)dz (7.8)
where z ∈ R
n
is a vector of uncorrelated Brownian motions. (Thus, g(X, t) ∈ R
n×n
and f(X, t) ∈ R
n
.)
We then assume that the short rate is a function of the underlying variables X. That is, r
0
(X, t). Note
that one possibility is to have the short rate be one of the variables in X. Thus, it is possible to choose
r
0
(X, t) = X
i
, where X
i
is the i −th factor.
66CHAPTER 7. APPLICATIONOF THE FACTOR FORM:INTEREST RATE ANDCREDIT DERIVATIVES
Now, to derive the pde that zero coupon bonds would follow, we just note that bonds are a function of
X and t. Hence, we have B(X, t|T). Via Ito’s lemma, our tradables become
¸
B
0
B(T)

d
¸
B
0
B(T)

=
¸
r
0
(X, t)B
0
B
t
(T)+B
X
(T)f(X, t)+
1
2
Tr[B
XX
(T)g(X, t)g
T
(X, t)]

dt +
¸
0
B
r
(T)g(X, t)

dz
where I have suppressed the X and t arguments in B. Now, by the price APT, we have
¸
B
0
B(T)

λ
0
+
¸
0
B
X
(T)g(X, t)

λ =
¸
r
0
(X, t)B
0
(B
t
(T) +B
X
(T)f(X, t) +
1
2
Tr[B
XX
(T)g(X, t)g
T
(X, t)])

(7.9)
where λ ∈ R
n
. The first equation gives λ
0
= r
0
(X, t) which is the random short rate. Then the second
equation gives
(B
t
(T) +B
X
(T)(f(X, t) −g(X, t)λ) +
1
2
Tr[B
XX
(T)g(X, t)g
T
(X, t)]) = r
0
(X, t)B(T) (7.10)
The boundary condition is of course that B(T|T) = 1. This can be a pretty complicated pde, and given that
it describes bonds as a function of λ, we could use the current term structure (or equivalently, bond prices)
to calibrate λ. This calibration can be quite difficult because bond prices are described by a pde, and to test
the fit for different values of λ, we might have to solve the pde every time. It is much easier if the solution
to the pde is known in closed form as a function of λ, then we can quickly adjust λ to best fit the market
data of bonds.
7.2.3 Heath-Jarrow-Morton
In the Heath-Jarrow-Morton [6] framework, instead of modeling the instantaneous short rate as driving
the term structure, they decided to model instantaneous forward rates. That is, let r(t|s) denote the
instantaneous forward rate seen from time t of the forward interest rate between time s and s + ds. With
this notational convention, we have that the instantaneous short rate is given by r(t|t) = r(t), and a zero
coupon bond with maturity T seen from time t will be denoted by B(t|T) and related to the instantaneous
short rates by
B(t|T) = exp

T
t
r(t|s)ds

. (7.11)
Hence, we also have that
r(t|T) = −

∂T
ln(B(t|T)). (7.12)
HJM takes the instantaneous forward rates as the underlying variables, and models them as
dr(t|s) = µ(t|s)dt +σ(t|s)dz(t). (7.13)
This model is a bit more complicated than the previous single and multi-factor short rate models because
we see through equation (7.11) that B(t|T) is a function of an infinite number of underlying variables r(t|s)
for s ∈ [t, T]! Because of this, if we were to write pricing formulas for derivatives, they would appear as
infinite dimensional pdes!
Nevertheless, this model has an advantage over the previous single and multi-factor short rate models
in that equation (7.11) gives us an explicit relationship between the tradables and the (inifinite) underlying
variables. Thus, instead of using a generic Ito’s lemma relationship between B(t|T) and the underlying
factors r(t|s), we will be able to make that relationship concrete by plugging in explicit partial derivatives
into Ito’s lemma.
Why is this helpful? Because this will allow us to pull the Price APT relationship for the marketed
tradables B(t|T) back to the underlying variables r(t|s) which opens up the possibility of doing calibration
7.2. INTEREST RATE DERIVATIVES 67
Figure 7.3: Notation for Zero Coupon Bond Prices
directly on the underlying factors r(t|s) instead of the marketed tradables. If it is easier to work with market
data about instantaneous forward rates, then this can simplify the calibration process. To understand the
value of this, you should consider the calibration procedure that has to be done for a single or multi-factor
short rate model if no closed form bond pricing formula is known (i.e. no closed form solution to the pricing
pde is known), and compare that with using forward rate data to calibrate in the HJM model that we will
derive.
Okay, with those preliminaries out of the way, let’s dive into the details. We will derive the Price APT
equations marketed tradables which are the bonds B(t|T). However, using the explicit relationship between
the bonds B(t|T) and the underlying variabels r(t|s) will allow us to pull the Price APT relationship back
to the underlying variables r(t|s) which would then allow us to calibrate using r(t|s) directly.
In this setup, we will take zero coupon bonds as our marketed tradables. That is, B(t|T) are tradables,
which means that we need to calculate dB(t|T) for our tradables table. This is a bit of a tricky calculation
because B(t|T) is really a function of an infinite number of Ito processes r(t|s) for s ∈ [t, T] through the
equation
B(t|T) = exp

T
t
r(t|s)ds

(7.14)
To simplify our thinking, let’s begin by assuming that s is indexed by k = 1...n so that B(t; T) will only
depend on n Ito processes. That is, let us think
B(t|T) = B({r(t|s
k
) : k = 1...n}, t|T) (7.15)
Then, by Ito’s lemma, we would have
dB =

¸
B
t
(t|s) +
n
¸
i=1
µ(t, s
i
)B
r(t|si)
+
n
¸
i=1
n
¸
j=1
1
2
σ(t|s
i
)σ(t|s
j
)B
r(t|si)r(t|sj)
¸

dt
+

n
¸
i=1
σ(t|s
i
)B
r(t|si)

dz
Now, to complete our computation of Ito’s lemma, we need to compute B
t
, B
r(t|si)
, and B
r(t|si)r(t|sj)
using
68CHAPTER 7. APPLICATIONOF THE FACTOR FORM:INTEREST RATE ANDCREDIT DERIVATIVES
the discretization of (7.14):
B(t|T) = exp


n
¸
k=1
r(t|s
k
)∆s
k

. (7.16)
This gives
B
t
≈ exp


n
¸
k=1
r(t|s
k
)∆s
k

r(t|t) = exp

T
t
r(t|s)ds

r(t|t) (7.17)
B
r(t|si)
≈ −exp


n
¸
k=1
r(t|s
k
)∆s
k

∆s
i
= −exp

T
t
r(t|s)ds

∆s
i
(7.18)
B
r(t|si)r(t|sj)
≈ exp


n
¸
k=1
r(t|s
k
)∆s
k

∆s
i
∆s
j
= exp

T
t
r(t|s)ds

∆s
i
∆s
j
. (7.19)
Plugging these into Ito’s lemma gives
dB(t|T) =

exp


n
¸
k=1
r(t|s
k
)∆s
k

r(t|t) −
n
¸
i=1
µ(t|s
i
) exp


n
¸
k=1
r(t|s
k
)∆s
k

∆s
i
+
1
2
n
¸
i=1
n
¸
j=1
σ(t|s
i
)σ(t|s
j
) exp


n
¸
k=1
r(t|s
k
)∆s
k

∆s
i
∆s
j
¸

dt

n
¸
i=1
σ(t|s
i
) exp


n
¸
k=1
r(t|s
k
)∆s
k

∆s
i

dz.
Taking continuous limits yields
dB(t|T) =

B(t|T)r(t|t) −B(t|T)

T
t
µ(t|s)ds +
1
2
B(t|T)

T
t

T
t
σ(t|s)σ(t|r)drds

dt

B(t|T)

T
t
σ(t|s)ds

dz.
Now, applying the Price APT equation leads to
r(t|t) −

T
t
µ(t|s)ds +
1
2

T
t

T
t
σ(t|s)σ(t|r)drds = r(t|t) −

T
t
σ(t|s)ds

λ
1
(7.20)
or

T
t
µ(t|s)ds −
1
2

T
t

T
t
σ(t|s)σ(t|r)drds =

T
t
σ(t|s)ds

λ
1
. (7.21)
The upshot of this calculation is that the mean and the volatilities of the forward rates r(t|s) must be related
through this equation. In fact, taking the partial derivative with respect to T gives
µ(t|T) −σ(t|T)

T
t
σ(t|s)ds = σ(t|T)λ
1
(7.22)
which makes the relationship a little more explicit. Thus, we have ”pulled back” the Price APT relationship
onto the underlying factors.
Again, to remind you, the point of this is that now we can calibrate from forward rate market date r(t|s)
rather than having to go through bond prices B(t|T).
7.2. INTEREST RATE DERIVATIVES 69
This is just the calibration phase. To price some derivative we would not have an explicit relationship
between the derivative and the underlying variables r(t|s), and thus Ito’s lemma (to create the tradables
table) combined with the Price APT would lead to an infinite dimensional pde. The point is that for actual
pricing of a new derivative, using the factor approach and pdes is not easy. This is one case in which risk
neutral pricing (Chapter 9) can help quite a bit.
7.2.4 The LIBOR Market Model
This model is similar to the HJM model except that it uses discrete forward rates instead of instantaneous
forward rates. Again, we will be able to use an explicit relationship between the marketed tradables of bonds
and the underlying variables of discrete forward rates to pull the Price APT relationship onto the underlying
variables. Once again, the idea is that this can make calibration easier. Due to its similarity with HJM, this
is also a model that is easier to price with using the risk neutral approach. Nevertheless, the factor approach
can provide us with an important perspective on this model. For further reading on this approach see [3].
Let R(t|T
1
; T
2
) be the forward interest rate between time T
1
and T
2
as seen at time t. For simplicity, let
T
i+1
= T
i
+ τ where τ is a fixed amount of time. Furthermore, we use an interest rate convention so that
the price of a zero coupon bond is
B(t|T
1
) =
1
(1 +τR(t|T
1
))
(7.23)
and for bond prices and forward rates we have
B(t|T
2
) =
B(t|T
1
)
(1 +τR(t|T
1
; T
2
))
(7.24)
and more generally
B(t|T
i
) =
B(t|T
i−1
)
(1 +τR(t|T
i−1
; T
i
))
(7.25)
etc for i = 1, ..., n.
Now, we will model the forward rates as stochastic differential equations. For simplicity, we use a
geometric Brownian motion model.
dR(t|T
1
; T
2
) = a
1
R(t|T
1
; T
2
)dt +b
1
R(t|T
1
; T
2
)dz
2
(7.26)
For notational simplicity, let’s write R
i
= R(t|T
i
, T
i+1
) and B
i
= B(t|T
i
) so that
dR
i
= a
i
R
i
dt +b
i
R
i
dz
i
(7.27)
Then prices of tradables satisfy
B
i
=
B
i−1
1 +τR
i−1
(7.28)
Now, it should be clear that B
i
depends on R
i−1
and hence the factor z
i−1
, but also B
i−1
. Now since B
i−1
depends on R
i−2
and B
i−2
, etc., then B
i
ultimately depends on the factors z
i−1
, z
i−2
, z
i−3
, ..., z
1
. Thus,
let us write generically that
dB
i
= µ
i
B
i
dt +B
i
i−1
¸
j=1
σ
ij
dz
j
. (7.29)
The relationship above leads to a recursive dependence
B
i
= (1 +τR
i
)B
i+1
. (7.30)
70CHAPTER 7. APPLICATIONOF THE FACTOR FORM:INTEREST RATE ANDCREDIT DERIVATIVES
Using Ito’s lemma gives
dB
i
= τdR
i
B
i+1
+ (1 +τR
i
)dB
i+1
+τdR
i
dB
i+1
(7.31)
= τB
i+1
(a
i
R
i
dt +b
i
R
i
dz
i
) + (1 +τR
i
)

¸
µ
i+1
B
i+1
dt +B
i+1
i
¸
j=1
σ
i+1,j
dz
j
¸

(7.32)
+τb
i
R
i
B
i+1

¸
i
¸
j=1
σ
i+1,j
ρ
ij
¸

dt (7.33)
=

¸
τB
i+1
(a
i
R
i
) +τb
i
R
i
B
i+1
i
¸
j=1
σ
i+1,j
ρ
ij
+ (1 +τR
i
)(µ
i+1
B
i+1
)
¸

dt
+τB
i+1
b
i
R
i
dz
i
+ (1 +τR
i
)

¸
B
i+1
i
¸
j=1
σ
i+1,j
dz
j
¸

. (7.34)
This is the expression for our tradables. From this we can get two things. First, we note that by comparing
this to (7.29) we should have that
τB
i+1
b
i
R
i
+ (1 +τR
i
)B
i+1
σ
i+1,i
= 0. (7.35)
Since the coefficient of z
i
in (7.29) is zero. This allows us to solve for σ
i+1,i
as
σ
i+1,i
= −
τb
i
R
i
(1 +τR
i
)
. (7.36)
Futhermore, equating the coefficients of z
j
for j < i in (7.29) and (7.34) gives
(1 +τR
i
)B
i+1
σ
i+1,j
= B
i
σ
i,j
. (7.37)
Now, noting that B
i
= (1 +τR
i
)B
i+1
gives
σ
i+1,j
= σ
i,j
. (7.38)
Thus, by combining (7.36) and (7.38) we obtain
σ
i+1,j
= −
τb
j
R
j
(1 +τR
j
)
, i > j. (7.39)
Once we have established these relationships, we can move to constructing the tradables table and
applying the Price APT. Returning to (7.34), the tradables look like
dB
i
=

¸
τB
i+1
(a
i
R
i
) +τb
i
R
i
B
i+1
i
¸
j=1
σ
i+1,j
ρ
ij
+ (1 +τR
i
)(µ
i+1
B
i+1
)
¸

dt
+τB
i+1
b
i
R
i
dz
i
+ (1 +τR
i
)

¸
B
i+1
i
¸
j=1
σ
i+1,j
dz
j
¸

(7.40)
= B
i

µ
i+1
+
τa
i
R
i
+τb
i
R
i
¸
i
j=1
σ
i+1,j
ρ
ij
1 +τR
i

dt
+B
i

¸
i−1
¸
j=1
σ
i+1,j
dz
j
¸

(7.41)
7.2. INTEREST RATE DERIVATIVES 71
where (7.39) was used in the last equality.
The Price APT then tells us that
µ
i
= r
0
+
i−1
¸
j=1
λ
j
σ
i+1,j
(7.42)
where r
0
is the short rate process, and from (7.41),
µ
i
=

µ
i+1
+
τa
i
R
i
+τb
i
R
i
¸
i
j=1
σ
i+1,j
ρ
ij
1 +τR
i

(7.43)
These equations mix parameters from the underlying variables (a
i
and b
i
), and the marketed tradables (µ
i
and σ
i,j
). We want conditions that don’t involve anything related to the marketed tradables. Thus, we
would like to eliminate µ
i
and σ
i,j
terms.
To do this, let’s substitute (7.42) into (7.43), giving
i−1
¸
j=1
λ
j
σ
i+1,j
=

¸
i−2
¸
j=1
λ
j
σ
i,j
+
τa
i
R
i
+τb
i
R
i
¸
i
j=1
σ
i+1,j
ρ
ij
1 +τR
i
¸

(7.44)
This still contains σ
i,j
terms. But, we can substitute in using (7.39) to get rid of those terms and have

i−1
¸
j=1
λ
j

τb
j
R
j
(1 +τR
j
)

=

¸

i−2
¸
j=1
λ
j

τb
j
R
j
(1 +τR
j
)

+
τa
i
R
i
−τb
i
R
i
¸
i
j=1

τbjRj
(1+τRj)

ρ
ij
1 +τR
i
¸

(7.45)
or
−λ
i−1

τb
i−1
R
i−1
(1 +τR
i−1
)

=

¸
τa
i
R
i
−τb
i
R
i
¸
i
j=1

τbjRj
(1+τRj)

ρ
ij
1 +τR
i
¸

(7.46)
which is the calibration relationship pulled onto the underlying variables of the discrete forward rates R
i
.
(Note that with n tradables as bond prices, we only have n−1 factors z
i
. Thus, there are only n−1 market
prices of risk, and that is why the above market price of risk is λ
i−1
and not λ
i
.)
Relations to HJM
The Libor Market Model is, of course, highly related to the HJM model. However, there are a couple of
difference that are helpful to point out. The first is that we derived that HJM as a single factor model (a
multifactor model is easy to do as well). That is, all the instantaneous forward rates were driven by the
same factor dz. In the Libor Market Model, each discrete forward rate is driven by a distinct factor dz
i
.
The next thing to note is that in the Libor Market Model, we used a recursive relationship to relate the
underlying variables to the marketed tradables
B
i
= (1 +τR
i
)
B
i−1
(1 +τR
i−1
)
(7.47)
which can be expanded to give
B
i
= (1 +τR
i
)
B
i−1
(1 +τR
i−1
)
=
i−1
¸
j=0
1
(1 +τR
i−1
)
(7.48)
This is, in fact, the discrete analog to the continuous equation used in HJM
B(t|T) = exp

T
t
r(t|s)ds

(7.49)
72CHAPTER 7. APPLICATIONOF THE FACTOR FORM:INTEREST RATE ANDCREDIT DERIVATIVES
Thus, the two models (HJM and Libor Market Model) really are brothers.
Finally, the most important thing to note about the HJM and Libor Market Model is that they can
both be viewed and understood from the factor point of view. This is typically not done because the risk
neutral framework turns out to be better suited for these models. However, it is important to understand
that these models all come from just a simple application of the factor approach, despite their looking quite
complicated. I hope you have found this exercise valuable... let’s move on to credit.
7.3 Credit Derivatives
Credit derivatives usually refer to derivatives that pay off depending on whether a bankruptcy has occured.
Since a bankruptcy is a sudden event, credit model rely heavily on Poisson processes. In what follows, I will
present the simplest models of a Defaultable Bond when the intensity of default is a constant, and then we
will generalize that to allow the intesity to be random. You should note the similarity between these models
and Merton’s jump diffusion model in Chapter 6, Section 6.1.6. In fact, if you understand Merton’s model
then there isn’t too much new here...
7.3.1 Defaultable Bonds
In deriving equations for defaultable bonds, we need two factors. The first is the short rate, and the second
is a default factor. We model these as
dr
0
= adt +bdz (7.50)
dN = dπ(α) (7.51)
In this case, a defaultable bond of maturity T is a function or r
0
, N, and t: B(r
0
, N, t|T). Since N(t) is a
pure Poisson process, we can start it at N = 0 which is the no default state, and let N = 1 be the default
state. By Ito’s lemma we can write, after suppressing all arguments except N:
dB(N) = LB(N)dt +bB
r
(N)dz + (B(N + 1) −B(N))(dπ(α) −αdt) (7.52)
where I have compensated the Poisson process and
LB(N) = (B
t
(N) +aB
r
(N) +
1
2
b
2
B
rr
(N) +α(B(N) −B(N + 1))) (7.53)
Now let’s write down the tradables table, which includes the money market account:
¸
B
0
B(N)

d
¸
B
0
B(N)

=
¸
r
0
B
0
LB(N)

dt +
¸
0 0
bB
r
(N) (B(N + 1) −B(N))
¸
dz
dπ −αdt

(7.54)
Finally, we solve the Price APT equations
¸
B
0
B(N)

λ
0
+
¸
0 0
bB
r
(N) (B(N + 1) −B(N))
¸
λ
1
λ
2

=
¸
r
0
B
0
LB(N)

(7.55)
From the first equation we have λ
0
= r
0
the short rate. The second equation gives
r
0
B(N) +bB
r
(N)λ
1
+ (B(N + 1) −B(N))λ
2
= LB(N) (7.56)
which can be rewritten as
B
t
(N) +aB
r
(N) +
1
2
b
2
B
rr
+α(B(N) −B(N +1)) = r
0
B(N) +λ
1
bB
r
(N) +λ
2
(B(N +1) −B(N)). (7.57)
But, we assume that we start with N = 0 and default is N = 1, so we have
B
t
(0) + (a −λ
1
b)B
r
(0) +
1
2
b
2
B
rr
(0) = (r
0
+α −λ
2
)B(0) + (λ
2
−α)B(1). (7.58)
7.3. CREDIT DERIVATIVES 73
Different Types of Recovery
But, since B(0) is the no default state, it is the same as B. Furthermore, B(1) means that we are in default.
Hence, we can assume different recoveries in default such as no recovery B(1) = 0, or fractional recovery
B(1) = xB(0), or even fixed recovery B(1) = X.
If we assume no recovery we obtain
B
t
(0) + (a −λ
1
b)B
r
(0) +
1
2
b
2
B
rr
(0) = (r
0
+α −λ
2
)B(0) (7.59)
This looks exactly like the standard model for a bond, except that the short rate is increased by α − λ
2
.
That is, the default rate and its market price of risk just adjust the short rate of interest. Otherwise, the
price is the same. This means that if there is a closed form solution for bond prices under a single factor
short rate model, then there will also be a closed form solution for defaultable bonds!
7.3.2 Defaultable Bonds with Random Intensity of Default
This time we will allow the default intensity to follow a stochastic differential equation. That is, we have
dr
0
= adt +bdz
1
(7.60)
dN = dπ(α) (7.61)
dα = fdt +gdz
2
(7.62)
where E[dz
1
dz
2
] = ρdt. In this case, a defaultable bond of maturity T is a function of r
0
, N, α and t:
B(r
0
, N, α, t|T). Again, we start with N = 0 which is the no default state, and let N = 1 be the default
state. By Ito’s lemma we can write:
dB(N) = LB(N)dt +bB
r
(N)dz
1
+gB
α
(N)dz
2
+ (B(N + 1) −B(N))(dπ(α) −αdt) (7.63)
where again I have compensated the Poisson process and this time
LB(N) = (B
t
(N)+aB
r
(N)+fB
α
(N)+
1
2
b
2
B
rr
(N)+
1
2
g
2
B
αα
(N)+ρbgB

(N)+α(B(N)−B(N+1))) (7.64)
Now let’s write down the tradables table:
¸
B
0
B(N)

d
¸
B
0
B(N)

=
¸
r
0
B
0
LB(N)

dt +
¸
0 0 0
bB
r
(N) gB
α
(N) (B(N + 1) −B(N))

dz
1
dz
2
dπ −αdt
¸
¸
(7.65)
Finally, we solve the Price APT equations
¸
B
0
B(N)

λ
0
+
¸
0 0 0
bB
r
(N) gB
α
(N) (B(N + 1) −B(N))

λ
1
λ
2
λ
3
¸
¸
=
¸
r
0
B
0
LB(N)

(7.66)
From the first equation we have λ
0
= r
0
the short rate. The second equation gives
r
0
B(N) +bB
r
(N)λ
1
+gB
α
(N)λ
2
+ (B(N + 1) −B(N))λ
3
= LB(N) (7.67)
which can be rewritten as
B
t
(N) +aB
r
(N) +fB
α
(N) +
1
2
b
2
B
rr
(N) +
1
2
g
2
B
αα
(N) +ρgbB

(N) +α(B(N) −B(N + 1))
= r
0
B(N) +λ
1
bB
r
(N) +λ
2
gB
α
(N) +λ
3
(B(N + 1) −B(N)).
But, we assume that we start with N = 0 and default is N = 1, so we have
B
t
(0)+(a−λ
1
b)B
r
(0)+(f−λ
2
g)B
α
(0)+
1
2
b
2
B
rr
(0)+
1
2
g
2
B
αα
(0)+ρgbB

(0) = (r
0
+α−λ
3
)B(0)+(λ
3
−α)B(1).
(7.68)
But, since B(0) is the no default state, it is the same as B(0). Furthermore, B(1) means that we are in
default. Hence, we can assume different recoveries in default such as no recovery B(1) = 0, or fractional
recovery B(1) = xB(0), or even fixed recovery B(1) = X.
74CHAPTER 7. APPLICATIONOF THE FACTOR FORM:INTEREST RATE ANDCREDIT DERIVATIVES
7.4 Problems
Problem 7.4.1 Derive a pde for the price of a European call option on a non-dividend paying stock when
interest rates are random, and the short rate follows Cox-Ingersoll-Ross dynamics. That is:
dS = µSdt +σSdz
1
(7.69)
dr
0
= a(b −r
0
)dt +c

r
0
dz
2
(7.70)
where dz
1
and dz
2
are correlated E[dz
1
dz
2
] = ρdt. Your answer may contain a market price of risk.
Problem 7.4.2 (Options on Forwards and Futures)
(a) Assume interest rates are stochastic and driven by a single factor short rate model. Derive the pde for a
derivative on a futures contract and on a forward contract.
Assume the following
df = µfdt +σfdz
dr
0
= adt +bdz
B
where f is either the forward price or futures price and E[dzdz
B
] = ρdt.
Hint 1: Recall that futures prices are marked to market (See Section 6.1.5 in Chapter 6, whereas forward
prices are not marked to market.
Hint 2: Note that a forward price is not tradable. However, you may assume that the asset that the
forward contract is on is tradable on a spot market and there are standard relationships between the spot
price of an asset and its forward price.
Hint 3: My recommendation is to let your underlying variables be the future and forward price, re-
spectively, and the short rate. Additionally, it might be convenient to write bond dynamics generically as
dB = µ
B
Bdt +σ
B
Bdz
B
, where the short rate process is being driven by z
B
.
(b) What if interest rates are not stochastic? Do the pdes for options on forwards and futures look the same?
Problem 7.4.3 (PDE for a derivative on a dividend paying stock under stochastic interest rates)
Consider a market with a stock price process S(t) satisfying
dS = µSdt +σSdz
1
(7.71)
where z
1
(t) is a standard Brownian motion. Assume that this stock also pays a continuous dividend at a rate
of q. Thus, over time dt, the dividend amount is qSdt.
Additionally, assume that interest rates are random, and the term structure is driven by a single factor
short rate model
dr
0
= a(b −r
0
)dt +fdz
2
(7.72)
where z
2
(t) is a standard Brownian motion and E[dz
1
dz
2
] = ρdt. Assume that a money market account
exists that satisfies
dB
0
= r
0
B
0
dt. (7.73)
Consider a third asset whose price at time t can be written as a twice differentiable function of S(t), r
0
(t)
and t. Call this price function c(S(t), r
0
(t), t). If no arbitrage exists in the market, derive the pde that
c(S(t), r
0
(t), t) must satisfy. (Your answer may contain a market price of risk.)
Problem 7.4.4 (Flat Term Structure)
Consider a term structure model where the term structure of interest rates is flat, but moves up and down
randomly. That is, let zero coupon bond prices with face value $1 and maturity T be denoted by B(t|T) and
satisfy
B(t|T) = exp(−r(T −t)) (7.74)
7.4. PROBLEMS 75
where r is modeled as a stochastic differential equation
dr = a(r, t)dt +b(r, t)dz. (7.75)
Note that this model applies for all maturities T.
(a) Write down models for the instantaneous return of the money market account and for a generic zero
coupon bond with maturity T (i.e. for B(t|T)).
(b) Derive the absence of arbitrage condition in this case, and derive restrictions on a(r, t) and b(r, t). What
does this imply about the allowable dynamics for this term structure?
76CHAPTER 7. APPLICATIONOF THE FACTOR FORM:INTEREST RATE ANDCREDIT DERIVATIVES
Chapter 8
Hedging
8.1 Introduction
We present two main approaches to hedging. In the first, we recognize that risk comes from the factors.
Thus, hedging is based upon eliminating factor risk. In the second approach, we consider a derivative to be
a function of underlying variables. We are then hedged against variations in these underlying variables if
the derivative of the value of a portfolio with respect to the underlying variables is zero. Thus, our portfolio
is not sensitive to small variations in the underlying variables.
8.2 Hedging from a Factor Perspective
In abstract terms, hedging involves eliminating factor risk. Once again, we can either work with returns or
prices. In this chapter, we will work with prices.
Let dV
u
be the value change of the asset that we would like to hedge. Furthermore, we will assume that
we hold one unit of this asset. Thus a factor model for our unhedged portfolio profit/loss over the next time
instance is
dV
u
= A
u
dt +B
u
dz (8.1)
and we would like to hedge this position.
By hedging, we actually just mean that we will form a portfolio (that may be dynamically traded over
time) so that the factor model of the portfolio eliminates all factor risk. In this case, we have entirely hedged
out the risk.
Let us consider having various tradable assets to hedge with, and assume that these assets have a value
profit/loss change vector of
dV
h
= A
h
dt +B
h
dz (8.2)
Now, let ˆ y be the holdings of the assets used to hedge with and let dV
0
be the value change of the hedged
portfolio. This change in value is given by
dV
0
= dV
u
+ ˆ y
T
dV
h
= (A
u
+ ˆ y
T
A
h
)dt + (B
u
+ ˆ y
T
B
h
)dz (8.3)
To eliminate the risk, we need to eliminate the coefficients of the factors. Thus, we need to choose ˆ y such
that
B
u
+ ˆ y
T
B = 0 (8.4)
That is really all there is to hedging!
77
78 CHAPTER 8. HEDGING
8.2.1 Description Using a Tradables Table
I like to use a tradables table description, so let’s rework the hedging analysis. Consider a tradables table
description, but add our holdings variable y
Holdings

y

Prices

P

Changes
d

V

=
Factor Model

A

dt +

B

dz
(8.5)
Let us assume that the last tradable is the derivative that we would like to hedge and we assume that
we hold one unit of that derivative. Hence, our holdings vector is actually
y =
¸
ˆ y
1

(8.6)
and the value change in the hedged portfolio is
dV
0
= y
T
dV = y
T
Adt +y
T
Bdz (8.7)
Thus, to hedge, we select ˆ y so that y
T
B = 0 (recalling of course that y is given by (8.6)).
8.2.2 The Relationship Between Hedging and Arbitrage
Hedging is actually quite closely related to arbitrage. In fact, a standard derivation of the Black-Scholes
equation begins from a hedging argument. In this section, let’s see how hedging and arbitrage are related.
Recall the arbitrage price implication
y
T
P = 0 No cost
y
T
B = 0 No risk

⇒ y
T
A = 0 No return (8.8)
Note that y
T
B = 0 is one of the conditions of the arbitrage price implication. Thus, from the line following
equation (8.7), a hedged portfolio will automatically satisfy this condition.
The other condition that needs to be satisfied to set up the arbitrage is that the total cost or price must
be zero, ˆ y
T
P = 0. Let’s see how we can alter our hedged portfolio to satisfy this no cost condition.
Creating a No Cost Hedge
Let’s break out the tradables table in a little more detail. First, lets assume that there is a tradable with no
direct factor risk
dB
0
= r
0
B
0
dt (8.9)
Additionally, using the notation above, the asset to be hedged satisfies
dV
u
= A
u
dt +B
u
dz (8.10)
and the tradables used to hedge this asset are
dV
h
= A
h
dt +B
h
dz (8.11)
We can write this in a tradables table form as

y
0
ˆ y
1
¸
¸

B
0
P
h
P
u
¸
¸
d

B
0
V
h
V
u
¸
¸
=

r
0
B
0
A
h
A
u
¸
¸
dt +

0
B
h
B
u
¸
¸
dz. (8.12)
where y
0
is the holding of B
0
, ˆ y is the holdings of the assets with value changes of dV
h
, and we hold a single
unit of the asset to be hedged.
8.2. HEDGING FROM A FACTOR PERSPECTIVE 79
Now, we make the following important observation. The holding in the first asset y
0
has no effect on
the hedge! Since it has no factor risk, including it in a portfolio has no effect on the factors! Hence, we can
choose its holding y
0
arbitrarily without affecting the hedge.
This recognition allows us to select y
0
so that the hedge has zero cost. That is, let ˆ y be the holdings of
a hedged portfolio, and then select y
0
so that the total cost is zero
y
0
B
0
+ ˆ y
T
P
h
+P
u
= 0 (8.13)
Thus, any completely hedged portfolio can be altered to satisfy the price APT implication. Thus, for no
arbitrage to exist, we must have zero profit/loss in this hedged portfolio. This means
y
0
rB
0
+ ˆ y
T
A
h
+A
u
= 0 (8.14)
This profit/loss condition is actually the Black-Scholes equation! Thus, a hedging strategy can be used to
derive the Black-Scholes equation via the above relationships.
A Simple Explanation
Here is the simple explanation of what we have done above. We hold an asset that we would like to hedge.
First, we use ˆ y to hedge away all the factor risk in our portfolio. Thus, the hedged portfolio has no direct
factor risk. Since it has no factor risk, for no arbitrage to exist it must be the same as the first tradable
that also has no factor risk. In the Black-Scholes setting, this first asset is the risk free asset, and all we
are saying is the the hedged portfolio must earn the risk free rate. In an interest rate derivative setting, the
tradable without direct factor risk is the money-market account and we are saying that the hedged portfolio
must earn the short rate. That is really all that we are doing with the above arguments!
8.2.3 Hedging Examples
Let’s see how hedging is done in some examples.
Hedging in Black-Scholes
In the Black-Scholes set-up of Chapter 6, Section 6.1.1 we have the following tradables table with the first
column being the holdings. We have assumed that we have one option c and that we are hedging with the
stock S. Thus, we assume the holding of the stock is ˆ y.

0
ˆ y
1
¸
¸

B
0
S
c
¸
¸
d

B
0
S
c
¸
¸
=

r
0
B
0
µS
c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
¸
¸
dt +

0
σS
σSc
S
¸
¸
dz. (8.15)
Now, this portfolio is hedged if y
T
B = 0 which in this case is
ˆ yσS +σSc
S
= 0 (8.16)
Solving for ˆ y gives ˆ y = −c
S
. Thus, we have a hedged portfolio if we hold −c
S
shares of the stock for every
option. The quantity c
S
is typically called the delta of the option.
Pricing
The above portfolio is hedged, but we can convert it to satisfy the arbitrage implication by choosing y
0
so
that the total cost is zero
y
0
B
0
−c
S
S +c = 0 (8.17)
80 CHAPTER 8. HEDGING
This is now a potential arbitrage portfolio. For no arbitrage to be present, we must have no profit/loss which
means that the drift term of our portfolio must be zero
y
0
r
0
B
0
−c
s
µS + (c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
) = 0 (8.18)
Substituting in (8.18) for y
0
B
0
= c
S
S −c from (8.17) gives
r
0
(c
S
S −c) −c
s
µS + (c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
) = 0 (8.19)
or
c
t
+r
0
Sc
S
+
1
2
σ
2
S
2
c
SS
= r
0
c (8.20)
which is the Black-Scholes equation.
Once again, the simpler explanation of this derivation is that the hedged portfolio is risk free and hence
must earn the risk free rate. I presented the more structured derivation because I believe that it is always
important to have structure to fall back on when your intuition fails. However, the intuition is important as
well!
Hedging in Bond Pricing
Consider the single factor short rate models of Chapter 7, Section 7.2.1. Following this model, let’s write
down the tradable table with holdings:

0
ˆ y
1
¸
¸

B
0
B
1
(T)
B
2
(T
0
)
¸
¸
d

B
0
B
1
(T)
B
2
(T
0
)
¸
¸
=

r
0
B
0
(B
1
t
(T) +aB
1
r
(T) +
1
2
b
2
B
1
rr
(T))
(B
2
t
(T
0
) +aB
2
r
(T
0
) +
1
2
b
2
B
2
rr
(T
0
))
¸
¸
dt +

0
bB
1
r
(T)
bB
2
r
(T
0
)
¸
¸
dz
(8.21)
Now, this portfolio is hedged if y
T
B = 0 which in this case is
ˆ ybB
1
r
(T) +bB
2
r
(T
0
) = 0 (8.22)
Solving for ˆ y gives ˆ y = −
B
2
r
(T0)
B
1
r
(T)
. Note that hedged portfolios of bonds are sometimes called ”immunized”.
Pricing
Using the same procedure as in the Black-Scholes case, we can convert this hedged portfolio into a potential
arbitrage portfolio and derive a pricing equation. Again, we choose y
0
so that the total cost is zero
y
0
B
0

B
2
r
(T
0
)
B
1
r
(T)
B
1
(T) +B
2
(T
0
) = 0 (8.23)
and note that for no arbitrage to exist, we must have no profit/loss
y
0
r
0
B
0

B
2
r
(T
0
)
B
1
r
(T)
(B
1
t
(T) +aB
1
r
(T) +
1
2
b
2
B
1
rr
(T)) + (B
2
t
(T
0
) +aB
2
r
(T
0
) +
1
2
b
2
B
2
rr
(T
0
)) = 0 (8.24)
Using y
0
B
0
=
B
2
r
(T0)
B
1
r
(T)
B
1
(T) −B
2
(T
0
) from (8.23) and substituting this into the first term in (8.24) gives
r
0

B
2
r
(T
0
)
B
1
r
(T)
B
1
(T) −B
2
(T
0
)


B
2
r
(T
0
)
B
1
r
(T)
(B
1
t
(T)+aB
1
r
(T)+
1
2
b
2
B
1
rr
(T))+(B
2
t
(T
0
)+aB
2
r
(T
0
)+
1
2
b
2
B
2
rr
(T
0
)) = 0
(8.25)
which can be rewritten as
B
2
t
(T
0
) +aB
2
r
(T
0
) +
1
2
b
2
B
2
rr
(T
0
) −r
0
B
2
(T
0
)
B
2
r
(T
0
)
=
B
1
t
(T) +aB
1
r
(T) +
1
2
b
2
B
1
rr
(T) −r
0
B
1
(T)
B
1
r
(T)
(8.26)
8.2. HEDGING FROM A FACTOR PERSPECTIVE 81
Now, since the left hand side only depends on B
2
and the right hand side only depends on B
1
and B
1
was
a bond of arbitrary maturity T, we must have that
B
1
t
(T) +aB
1
r
(T) +
1
2
b
2
B
1
rr
(T) −r
0
B
1
(T)
B
1
r
(T)
= λ

(8.27)
for some constant λ

. To make this look like our previously derived bond pricing equation in Chapter 7
Section 7.2.1, let’s let
λ

= λb (8.28)
so that (8.27) can be written as
B
1
t
(T) +aB
1
r
(T) +
1
2
b
2
B
1
rr
(T) −r
0
B
1
(T)
B
1
r
(T)
= λb (8.29)
Upon rearranging we have
B
1
t
(T) + (a −λb)B
1
r
(T) +
1
2
b
2
B
1
rr
(T) = r
0
B
1
(T) (8.30)
which is the bond pricing equation where λ is the market price of risk.
The intuitive explanation of this derivation is that first we hedge out the factor risk by the choice of ˆ y.
Since this hedged portfolio has no factor risk, it must earn the same return as the tradable with no factor
risk, which is the money market account. This is where the pricing pde comes from!
8.2.4 Hedging under Incompleteness
In some cases it is impossible to eliminate all of the factor risk (this is true in incomplete markets). In this
case, we may still attempt to reduce the effect of the factors on our portfolio. But, we will have choices in
terms of how we want to best try to reduce risk from the factors.
To see how this is done, let’s consider an example. In the jump diffusion model of Chapter 6 Section
6.1.6, we had the following tradables table.

0
y
1
¸
¸

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
(µ +αE[Y −1])S
Lc
¸
¸
dt +

0 0 0
σS S 0
σSc
S
0 1
¸
¸

dz

1

2
¸
¸
(8.31)
where L is the differential operator corresponding to the drift term in Ito’s lemma, and

1
= (Y −1)dπ(α) −αE[Y −1]dt (8.32)

2
=

(c(Y S

) −c(S

))dπ −αE[(c(Y S

) −c(S

))]dt

(8.33)
I have added the vector of holdings on the left side of the tradables table. I have assumed that I hold 1 unit
of the derivative c, and that I will hedge with the stock S. Since the bond B is not driven by any of the
risky factors, I do not need to consider it in the hedge.
So, the hedged portfolio takes the form
dV
h
= ydS +dc (8.34)
= y((µ +αE[Y −1])Sdt +σSdz +Sdψ
1
) +Lcdt +Sc
S
dz +dψ
2
(8.35)
= [y(µ +αE[Y −1])S +Lc]dt + [yσS +Sc
S
]dz +ySdψ
1
+dψ
2
(8.36)
One can clearly see that it is not possible to eliminate all the factor risk by choosing y. Thus, we are in an
incomplete market.
82 CHAPTER 8. HEDGING
However, we can select y to eliminate some of the risk over the next dt. In fact, what Merton [11] did in
his pricing formula is equivalent to eliminating the Brownian risk dz. In that case, we would choose
y = −c
S
(8.37)
where c
S
is the partial derivative of Merton’s pricing formula.
But, let’s consider a different alternative. Let’s choose y to eliminate the variance of the portfolio over
the next dt. That is
V ar(dV
h
)
=

E[A
2
] −2yE[AB] +y
2
E[B
2
]

λdt +

V ar(A) −2yCov(A, B) +y
2
V ar(B)

λ
2
dt
2
+ [σSc
S
−yσS]
2
dt
(8.38)
where
A = c(Y S(t

), t) −c(S(t

), t

) (8.39)
B = B(Y −1)S. (8.40)
Minimizing over y gives
y =
λE[AB] +λ
2
dtCov(A, B) +σ
2
S
2
c
S
λE[B
2
] +λ
2
dtV ar(B) +σ
2
S
2
(8.41)
and sending dt → 0 leads to
y =
λE[AB] +σ
2
S
2
c
S
λE[B
2
] +σ
2
S
2
. (8.42)
8.2.5 A Question of Consistency
Note that the hedges we have derived above often involve knowledge of a pricing formula for the option c.
This can be seen by noting that y is often a function of c
S
for instance. Thus, our hedging analysis has
presupposed that the derivative c follows a specified formula that we know.
This presupposition of knowledge can bring up a question of consistency between the hedge and the
assumption of the formula for c. Consider the following example.
Let’s consider a stochastic volatility model:
dB = r
0
Bdt (8.43)
dS = µSdt +

vSdz
1
(8.44)
dv = adt +bdz
2
(8.45)
with the tradables table

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
µS
Lc
¸
¸
dt +

0 0

vS 0

vSc
S
bc
v
¸
¸
¸
dz
1
dz
2

. (8.46)
with Lc = c
t
+µSc
S
+ac
v
+
1
2
vS
2
c
SS
+
1
2
b
2
c
SS


vbSc
Sv
.
Now, this is an incomplete market, so we cannot perfectly hedge away the risk. Nevertheless, let’s consider
a hedged portfolio
dV
h
= y(µSdt+

vSdz
1
)+(c
t
+µSc
S
+ac
v
+
1
2
vS
2
c
SS
+
1
2
b
2
c
vv


vbSc
Sv
)dt+

vSc
S
dz
1
+bc
v
dz
2
(8.47)
Clearly, with y, we cannot eliminate all the risk. Let’s consider a simple hedge where we only eliminate the
dz
1
risk. Thus, we choose y

vS +

vSc
S
= 0 or y = −c
S
.
Thus, our hedge is to hold −c
S
shares of the stock. But, what is c
S
?
Well, how about using the Black-Scholes formula for c(S, t) and computing c
S
from that? But, this is
not consistent because to derive the Black-Scholes formula we assume that volatility is not stochastic. In
our setting above, we are assuming that volatility is stochastic and thus there is no reason to believe that c
would follow the Black-Scholes equation. This is where the inconsistency in hedging often arises.
8.3. HEDGING FROM AN UNDERLYING VARIABLE SENSITIVITY PERSPECTIVE 83
What formula for c?
So, you ask, then what formula should I use for c. The answer is that you should use the formula that best
corresponds to the actual price and movements of c in the market. Thus, if there is stochastic volatility,
then you should use a model that most accurately captures that stochastic volatility and how it is reflected
in the movement of the derivative c.
Now, some might argue that you should use a pricing formula that comes from the hedge that you are
doing. As we saw above, pricing and hedging are intimately related. This idea is both right and wrong.
Let’s see why.
Here is the correct part. Any pricing formula should be related to a reasonable hedging scheme via
our analysis above. Why? Because hedging is the mechanism that enforces pricing. If there is no hedging
justification for a pricing formula, then there is no good reason to expect that pricing formula to hold.
However, if a pricing formula is tightly related to a hedging strategy, then deviations from that pricing
strategy can be exploited by turning the hedging strategy into an arbitrage (or almost arbitrage) opportunity
as shown in the previous section.
Here is the wrong part. Sometimes, you want to hedge for a reason unrelated to pricing. For example, in
the stochastic volatility case I might just want to hedge out the stock risk S via dz
1
and leave my portfolio
exposed to volatility risk. If I were interested in using some trading strategy that depended on volatility v
but not the stock price S, then this would be perfectly reasonable. But it probably would not be reasonable
to claim that I should be using a pricing formula related to this hedging strategy. The pricing formula c
that I should be using is the one that best reflects the actual movement of c in the market.
To summarize, every pricing formula should be intimately connected to a hedging strategy. However,
the reverse is not true. Not every hedging strategy should be turned into a pricing formula. Furthermore,
hedging strategies often rely on a pricing formula for the derivative c. This pricing formula should be the
best pricing formula that reflects the actual pricing and movement of the derivative c in the actual market.
In practice, many times that is not done (for many reasons, including computational, ease of use, etc).
Thus, often hedging analysis is inconsistent. For example, people like to rely on the Black-Scholes formula
even when its assumptions are not valid. Due to standard finance conventions, in places below we will fall
into this trap as well, so keep a sharp eye out for where it may be occurring.
8.3 Hedging from an Underlying Variable Sensitivity Perspective
In some cases, there is a simpler and faster way to derive hedges that doesn’t involve an explicit use of the
factors. In this approach, we consider the asset that we are trying to hedge to be a function of underlying
variables, and hedge against those variables by eliminating the sensitivity to those underlying variables. In
the simplest terms, sensitivity is measured by the derivative of the hedged portfolio with respect to the
underlying variable of concern.
8.3.1 Black-Scholes Hedging
For example, in the Black-Scholes setup, we assume that an option is a function of the underlying stock S
and time t. That is, the price of an option is a function of the variables S and t which we write as c(S, t).
Now if we would like to hedge out the risk in our option, we note that all the risk in the price of an option
comes from its dependence on the stock variable. Hence, we form a hedged portfolio
P
h
= c(S, t) + ˆ yS (8.48)
and want to choose ˆ y so that this portfolio is hedged. But, in this case, since all the risk comes from the
stock variable, we will be hedged if our portfolio has no sensitivity to changes in the stock. Another way of
saying this is that we want the derivative of P
h
with respect to S to be zero. That means that small changes
in S will cause no change in the value of the hedged portfolio P
h
. Thus, we will be hedged.
84 CHAPTER 8. HEDGING
This condition can be written as
∂P
h
∂S
= c
S
+ ˆ y = 0 (8.49)
Solving for ˆ y yields ˆ y = −c
S
which is the same answer that we arrived at using factors. This hedge is known
as a delta hedge and the quantity c
S
is commonly referred to as the delta of the option.
There is a simple graphical interpretation of this hedge. Consider a plot with the underlying variable
on the x-axis, and the value of the tradable as a function of the underlying factor on the y-axis. In this
case, the underlying variable is the stock price S and the tradables are the stock itself S and the option c.
For simplicity, let’s assume the option is a European call option following Black-Scholes. Figure 8.1 shows
a plot of the stock, call option, and delta hedged portfolio for an option with strike K = 10 and expiration
T = 0.3 on a stock with volatility σ = 0.3 and an interest rate of r
0
= 0.05. The hedged portfolio on the
right in Figure 8.1 is a portfolio of the stock (left) and call option (middle) so that at the current value of
the underlying variable (S = 10), the derivative of the portfolio value yS +c is zero (right plot).
0 5 10 15
−10
−5
0
5
10
15
Stock Value
Underlying Variable: S
T
r
a
d
a
b
le
: S
0 5 10 15
−10
−5
0
5
10
15
Option Value
Underlying Variable: S
T
r
a
d
a
b
le
: c
0 5 10 15
−10
−5
0
5
10
15
Hedged Portfolio
Underlying Variable: S
T
r
a
d
a
b
le
: H
e
d
g
e
d
P
o
r
tfo
lio
Figure 8.1: Delta Hedge: Left - Plot of the Stock, Middle - Plot of the option, Right - Plot of the hedged
portfolio assuming that the current price of the stock is $10.
To make this a potential arbitrage portfolio, we could add a position in the bond in order to make the
current price of the portfolio (at S = $10) be zero.
8.3.2 Hedging Bonds
We can apply this same underlying variables approach to our hedging of bonds. In that case, we hold a
bond B
2
(r
0
, t|T
0
) that is a function of the short rate r
0
(t) and time t. We wish to hedge this bond with
another bond B
1
(r
0
, t|T) that is also a function of the short rate r
0
(t) and time t. In this setup, the risk
in the price of a bond comes from the short rate r
0
(t) which is our underlying variable. Thus, a portfolio
P
h
= B
2
(r
0
, t|T
0
) + ˆ yB
1
(r
0
, t|T) is hedged if its derivative with respect to r
0
is zero. Thus
∂P
h
∂r
= B
2
r
(T
0
) + ˆ yB
1
r
(T) = 0 (8.50)
Solving for ˆ y yields ˆ y = −
B
2
r
(T0)
B
1
r
(T)
which is the same answer that we arrived at using factors.
8.3.3 Derivatives imply Small Changes
Note that this underlying variable approach uses the derivative as a measure of sensitivity. Recall that the
derivative is the change in a function for a small change in the variable. Thus, when we say that a portfolio
is hedged against stock price movements because its derivative with respect to the stock is zero, this means
that the value of the portfolio change is approximately zero for small changes in the price of the stock. But,
the value of the portfolio change could be quite large if the stock change is large. Hence, this approach only
works if we know that the stock price changes will be small. This is the case for stock price movements
driven by Brownian motion since Brownian motion is continuous. However, if the stock price is driven by a
8.4. HIGHER ORDER APPROXIMATIONS 85
Poisson process, then we would expect it to have large jumps at times. Thus, in this case using the derivative
is not a good approach since the stock price change would be large and the derivative would likely not be
a good approximation to the change in the portfolio value. This was the situation in the Jump-Diffusion
model above, and note that the hedging strategy that we derived was not that same one that would result
from this derivative approach.
8.4 Higher Order Approximations
Using the derivative to model the change in a portfolio due to the change in a variable is a linear approxi-
mation of portfolio value as a function of the underlying variable. Of course, one can also use a higher order
approximation to the portfolio value. An easy way to do this is to use the terms of a Taylor expansion. This
leads to the so-called Greeks, presented next.
8.4.1 The Greeks
Now, in general, a call option is not just a function of the price of the stock and time. From the Black-
Scholes formula, we see that it depends also on the risk free rate r
0
and the volatility of the option σ. In
our derivation of the Black-Scholes formula, we assumed that r
0
and σ were constant (not random factors).
However, recognizing that that is only an approximation, we can allow them to be underlying variables and
change. Then we can ask how their changes might cause the price of an option to change assuming that the
price follows the Black-Scholes formula. To do this, we would just construct a multivariable Taylor series
expansion of c(S, t, r
0
, σ) as
∆c(S, t, r
0
, σ) = c
t
∆t +c
S
∆S +c
r
∆r
0
+c
σ
∆σ +
1
2
c
SS
(∆S)
2
+... (8.51)
I only included a single second order term (there are many second order terms) because is it the only named
second order term.
By looking at this Taylor expansion, we see that the various derivatives tell us the sensitivity of the price
of an option to changes in those variables. Each of these derivatives is given a Greek letter name as in Table
8.1.
theta c
t
delta c
S
rho c
r
vega c
σ
gamma c
SS
Table 8.1: The Greeks
If you have a bad memory, like I do, then you can remember some of the Greeks by noting that the first
letter of the Greek is the same as the partial derivative. That is, ”theta” starts with ”t” and is the partial
with respect to t. Similarly, ”rho” starts with ”r” and is with respect to r
0
, and ”vega” starts with ”v” and
is the partial with respect to ”v”olatility. Unfortunately, with ”delta” and ”gamma” you are on your own.
Note that in the typical dynamic hedging assumption, we are able to trade continuously. Thus, only
terms of order dt and lower matter. However, this Taylor expansion approach assumes that we are not
trading continuously. Thus, we use a ∆t instead of a dt and furthermore, higher order terms will enter. This
is actually more practical than the typical continuous time trading assumptions.
8.4.2 A Delta-Gamma Hedge
One can think of a delta hedge as eliminate the first order term in the Taylor expansion. Of course, one can
go further and ask if higher order terms can be eliminated as well. If you elminate the first order term in
86 CHAPTER 8. HEDGING
∆S and the second order term (∆S)
2
than this is called a Delta-Gamma hedge. For such a Delta-Gamma
hedge you need more than just the underlying stock, and furthermore, you need a tradable that depends on
the second order term (∆S)
2
. Let’s show how by using another call option c
(2)
and the underlying stock,
we can Delta-Gamma hedge an option c.
In this case, the hedged portfolio is
P = c +y
1
S +y
2
c
(2)
(8.52)
and let’s Taylor expand this to obtain
∆P(S, t) = ∆c(S, t) +y
1
∆S +y
2
∆c
(2)
(8.53)
=
¸
c
t
∆t +c
S
∆S +
1
2
c
SS
(∆S)
2

+y
1
∆S +y
2
¸
c
(2)
t
∆t +c
(2)
S
∆S +
1
2
c
(2)
SS
(∆S)
2

(8.54)
=

c
t
+y
2
c
(2)
t

∆t +

c
S
+y
1
+y
2
c
(2)
S

∆S +
¸
1
2
c
SS
+y
2
1
2
c
(2)
SS

(∆S)
2
(8.55)
To Delta-Gamma hedge, we have to eliminate the coefficients of ∆S and (∆S)
2
by choosing y
1
and y
2
. Thus,
we must solve
c
S
+y
1
+y
2
c
(2)
S
= 0 (8.56)
1
2
c
SS
+y
2
1
2
c
(2)
SS
= 0 (8.57)
The solution is
y
1
=
c
SS
c
(2)
SS
c
(2)
S
−c
S
, y
2
= −
c
SS
c
(2)
SS
(8.58)
In the plots of Figure 8.1, this would create a portfolio that has the first and second derivative equal to zero
at the current value of the underlying variable.
In practice, Delta-Gamma hedges (and other hedges as well) are difficult because transaction costs can
make it expensive to trade too many assets.
8.4.3 Determining what the error looks like
We can use the Taylor expansion to see what the error looks like in a Delta hedge under Black-Scholes
assumptions. Consider the hedged portfolio
P(S, t) = c(S, t) −c
S
S (8.59)
and let’s perform a Taylor expansion of this in S and t
∆P(S, t) = ∆c(S, t) −c
S
∆S (8.60)
= c
t
∆t +
1
2
c
SS
(∆S)
2
dt +... (8.61)
= c
t
∆t +
1
2
c
SS
σ
2
S
2
dt +... (8.62)
where I have only kept terms up to order ∆t in (8.62). However, (8.61) is also a very useful equation for
intuituion. So we will use it as well. Note that the only difference between (8.61) and (8.62) is that (∆S)
2
is
σ
2
S
2
dt + higher order terms. For the analysis that we are looking at, the higher order terms don’t matter.
Now let’s assume that in the market, c satisfies the Black-Scholes equation corresponding to a volatility
value of σ
i
. Thus,
c
t
+r
0
Sc
S
+
1
2
σ
2
i
S
2
c
SS
= r
0
c (8.63)
I use the subscript i on the volatility σ
i
to denote what is known as implied volatility. Implied volatility
is the value of volatility that when plugged into the Black-Scholes formula will make it equal the current
8.5. SUMMARY 87
market price of an option. To be more concrete, let c
m
be the current market price of an option where
the stock price is S
0
, strike price is K, time to expiration is T, and risk free rate is r
0
. Furthermore, let
c
BS
(S, K, T, r
0
, σ) denote the Black-Scholes formula. Then the implied volatility is defined as the value of
σ
i
that solves
c
m
= c
BS
(S
0
, K, T, r
0
, σ
i
) (8.64)
Thus, it answers the question: If the market is following Black-Scholes, what volatility value are they pluggin
in the Black-Scholes formula?
Thus, (8.63) assumes that the market is pricing the option using the Black-Scholes formula with a
volatility value of σ
i
. Thus, we can use (8.63) to substitute for c
t
in (8.61) which gives
∆P(S, t) = r
0
(c −c
S
S)dt +
1
2
c
SS

(∆S)
2
−σ
2
i
S
2

dt (8.65)
and finally noting that P = c −c
S
S gives
∆P(S, t) = r
0
Pdt +
1
2
c
SS

(∆S)
2
−σ
2
i
S
2

dt (8.66)
or purely to order dt using (8.62) instead of (8.61),
∆P(S, t) = r
0
Pdt +
1
2
c
SS

σ
2
−σ
2
i

S
2

dt. (8.67)
Equation (8.66) shows that the gain or loss of our hedged portfolio relative to the risk free rate depends on
the actual change in the stock price over the next ∆t in the term (∆S)
2
relative to the implied volatility
σ
i
in Black-Scholes that is being used to price the option in the market. Equation (8.67) shows the same
thing, but in terms of the volatility of the stock σ rather than the stock move ∆S. In particular, for this
hedge where we are long the option and short delta of the stock, we make money if the stock moves more
than implied volatility estimate, and we lose money if it moves less.
8.5 Summary
Hedging can be approach from two different points of view. In the first point of view, we recognize the fact
that risk comes from the factors. Thus, in hedging we try to eliminate the factor risk. This point of view
is appropriate regardless of what the risky factors are. In the second point of view, tradables are viewed as
functions of underlying variables, and we hedge by constructing a portfolio that eliminates the sensitivity to
moves in the underlying variables. Usually we do this by setting the derivative of the hedged portfolio with
respect to the underlying variable to zero at the current value of the underlying variable. Since we only set
the derivative to zero, and the derivative reflects a local approximation to the portfolio, this works as long
as there are only small moves in the underlying variable between rehedging opportunities. Furthermore, if
we have more tradables to place in our portfolio, we can set higher order derivatives of our portfolio to zero
as well and create better hedges. Really, if you underlying Taylor expansions, then you are on your way to
understanding the majority of hedging methods.
8.6 Problems
Problem 8.6.1 Verify equation (8.38).
88 CHAPTER 8. HEDGING
Chapter 9
The Road to Risk Neutrality
9.1 Introduction
Risk neutral absence of arbitrage pricing is a widely used approach to derivative pricing. However, it tends
to be one of the most confusing, misunderstood, and misused pricing approaches, especially for those new
to derivative pricing. Nevertheless, when understood correctly, it is an extremely powerful approach. Thus,
in this chapter, I will explain the risk neutral pricing principle. This introduction to risk neutral pricing
does not follow the standard probability-heavy route, but instead motivates risk neutral pricing in a simple
manner from the factor approach.
9.2 Do the Factors Matter?
In our tradables table, we have
Prices

P

Changes
d

V

=
Factor Model

A

dt +

B

dz
(9.1)
and the absence of arbitrage condition is
A = Pλ
0
+Bλ (9.2)
Thus, absence of arbitrage only depends on the values of P, A, and B, and not on what the exact factors
dz are. Therefore, the prices P are absence of arbitrage for any value change with A, and B, regardless of
what the driving factors are. This leads us to ponder the following.
Hypothesis: Perhaps by changing the factors from dz to some other random factors dψ, where the A and
B representation of prices changes is the same, I can compute the absence of arbitrage prices P easier.
To see whether something can be made of this hypothesis, we have to start with a more basic question.
Question: Given a set of factors dz, what other set of factors dψ will have the same A and B representation?
At first glance, you might be tempted to say that I can choose dψ to be anything I want. It doesn’t have
to relate to the original dz at all because the absence of arbitrage condition ”does not see” dz. However,
you would soon realize that this is not the case.
Why? Because when we deal with derivative securities, their factor model is determined by the application
of Ito’s lemma. Thus, the A and B representation of price changes does see the factors via Ito’s lemma.
Hence, Ito’s lemma puts a constraint on which factors dψ are consistent with the original factors dz. Let’s
be a little more concrete about this.
89
90 CHAPTER 9. THE ROAD TO RISK NEUTRALITY
Let S(t) be a stock price with model
dS = µSdt +σSdz (9.3)
and let c(S, t) be a derivative security. By Ito’s lemma we have
dc =

c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS

dt +σSc
S
dz. (9.4)
Thus, the tradables table is
Prices
¸
S
c

Changes
d
¸
S
c

=
Factor Model
¸
µS

c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS

dt +
¸
σS
σSc
S

dz.
(9.5)
9.2.1 Brownian Factors
Changing the Mean Works
Let’s try new factors given by the replacement
dz → dψ = d˜ z +βdt (9.6)
That is, I will replace the original Brownian factors dz by a new factor that is a Brownian d˜ z plus a drift
βdt. It is important to consider the new factor to be the entire term dψ = d˜ z +βdt and not just d˜ z!
We can ask whether this will lead to a representation consistent with the original dz. We would have
dS = µSdt +σS(dψ) (9.7)
= µSdt +σS(d˜ z +βdt) (9.8)
= (µ +σβS)dt +σSd˜ z (9.9)
and then by Ito’s lemma we have for c(S, t),
dc =

c
t
+ (µ +σβ)Sc
S
+
1
2
σ
2
S
2
c
SS

dt +σSc
S
d˜ z (9.10)
=

c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS

dt +σSc
S
(d˜ z +βdt) (9.11)
=

c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS

dt +σSc
S
(dψ) (9.12)
And thus we see that dz and dψ = d˜ z + βdt are consistent in that they produce the same A and B
representation regardless of whether dz or dψ = d˜ z +βdt is the factor!
The upshot is that we can replace any Brownian factors dz by Brownians plus a drift d˜ z +βdt, and the
same absence of arbitrage prices hold!
Changing the Variance Does Not Work
Let’s try new factors given by the replacement
dz → dψ = ηd˜ z (9.13)
That is, I will replace the original Brownian factors by Brownians with a different variance. Again, the new
factor should be considered to be the entire term dψ = ηd˜ z and not just the d˜ z. We can ask whether this
factor dψ = ηd˜ z is consistent with the original dz. We would have
dS = µSdt +σS (dψ) (9.14)
= µdt +σS(ηd˜ z) (9.15)
9.2. DO THE FACTORS MATTER? 91
and then by Ito’s lemma we have for c(S, t),
dc =

c
t
+µSc
S
+
1
2
σ
2
η
2
S
2
c
SS

dt +σSc
S
(ηd˜ z) (9.16)
=

c
t
+µSc
S
+
1
2
σ
2
η
2
S
2
c
SS

dt +σηSc
S
(dψ) (9.17)
(9.18)
Thus, we see that A is changed when we change the factor to another Brownian with a different variance.
Therefore, this substitution is not allowed.
Similarly, in the case of multiple Brownian factors, changes in the correlations or the covariance structure
is not allowed. The above results lead us to the following principle.
(⋆) Arbitrage Invariance Principle for Brownian Motion: If a set of prices P is absence of arbitrage
under Brownian factors dz ∈ R
n
with E[dzdz
T
] = Σdt, then P is also absence of arbitrage if the factors dz are
replaced by dz → dψ = d˜ z +βdt with β arbitrary and where d˜ z are Brownian factors with E[d˜ zd˜ z
T
] = Σdt.
9.2.2 Poisson Factors
Changing the Intensity Works
Assume that the original factor is a Poisson Process dπ(t; α). Under dπ(t; α) we have
dS = µSdt + (σ −1)Sdπ(t; α) (9.19)
dc = (c
t
+µSc
S
)dt + (c(σS) −c(S))dπ(t; α). (9.20)
Now, let’s consider changing the factor to a Poisson with an altered intensity dψ = d˜ π(t; α + β) where
α +β > 0. In this case, we have
dS = µSdt + (σ −1)Sd˜ π(t; α +β) (9.21)
dc = (c
t
+µSc
S
)dt + (c(σS) −c(S))d˜ π(t; α +β) (9.22)
and we see that the A and B representations remain the same under dψ = d˜ π(t; α +β).
Adding a Drift Doesn’t Work
Again assume that the original factor is a Poisson Process dπ(t; α). Under dπ(t; α) we have
dS = µSdt + (σ −1)Sdπ(t; α) (9.23)
dc = (c
t
+µSc
S
)dt + (c(σS) −c(S))dπ(t; α) (9.24)
Now, let’s consider changing the factor dπ(t; α) → dψ = d˜ π(t; α) +ηdt. In this case, we have
dS = µSdt + (σ −1)Sdψ = µSdt + (σ −1)S(d˜ π(t; α) +ηdt) (9.25)
dc = (c
t
+ (µS + (σ −1)ηS)c
S
)dt + (c(σS) −c(S))d˜ π(t; α) (9.26)
and we see that there is no way to recover the original A and B representations under dψ.
(⋆) Arbitrage Invariance Principle for Poisson: If a set of prices P is absence of arbitrage under
Poisson factors dπ
i

i
), then P is also absence of arbitrage under a different set of factors dψ = d˜ π
i

i

i
)
where α
i

i
is the new intensity.
92 CHAPTER 9. THE ROAD TO RISK NEUTRALITY
9.3 Risk Neutral Representations
The Brownian and Poisson factor invariance principles tell us that it is okay to alter or replace the factors in
certain ways. Why is this helpful? Because in some situations it is easier to price a derivative if we replace
the factors by something different from the original factors. In fact, in this section we show that we can
always replace the factors and put all tradables in what we will call a risk neutral representation. The fact
that we can do this will ultimately lead us to the risk neutral pricing principle. The basic idea is that for any
pricing problem, we can replace the factors to create the risk neutral representation which leads to simplified
pricing formulas. But we are getting ahead of ourselves. First, let’s see what the risk neutral representations
are.
9.3.1 Brownian Factors
Consider the tradables table with Brownian factors dz
Prices

P

Changes
d

V

=
Factor Model

A

dt +

B

dz
(9.27)
and the absence of arbitrage condition is A = Pλ
0
+ Bλ. Now, we can substitute this into the tradables
table to obtain
Prices

P

Changes
d

V

=
Factor Model


0
+Bλ

dt +

B

dz
(9.28)
Finally, we groups terms differently to obtain
Prices

P

Changes
d

V

=
Factor Model


0

dt +

B

(dz +λdt)
(9.29)
Now, by the Brownian factor invariance under changes to the drift, we can replace dz → dψ = d˜ z − λdt,
which leads to
Prices

P

Changes
d

V

=
Factor Model


0

dt +

B

d˜ z
(9.30)
This is the risk neutral representation. It states that we can find a replacement set of factors so that all
tradables have a drift equal to the market price of time λ
0
, and absence of arbitrage prices under this
representation will be the same as under the original representation using the actual Brownian factors.
Note that to obtain this risk neutral representation, the factors were replaced by new factors that con-
tained the market prices of risk! Let’s formalize this notion of a risk neutral representation.
(⋆) Risk Neutral Representation for Brownians: Let
Prices

P

Changes
d

V

=
Factor Model

A

dt +

B

dz
(9.31)
be a tradables table. Then, under arbitrage invariant substitutions of the factors dz → dψ = d˜ z − λdt, the
following tradable table will produce the same absence of arbitrage prices
Prices

P

Changes
d

V

=
Factor Model


0

dt +

B

d˜ z
(9.32)
Equation (9.32) is called the risk neutral representation because all tradables have a drift equal to the market
price of time, regardless of how risky they really are.
9.3. RISK NEUTRAL REPRESENTATIONS 93
9.3.2 Poisson Factors
Consider the tradables table with Poisson factors dπ(t, α).
Prices

P

Changes
d

V

=
Factor Model

A

dt +

B

dπ(t; α)
(9.33)
and the absence of arbitrage condition is
A = Pλ
0
+Bλ (9.34)
Before proceeding, let’s think about the market price of risk for a Poisson factor dπ. Since a Poisson process
either does nothing or jumps up by 1, it is always good to hold a positive amount of a Poisson factor. All
the risk is on the upside. On the other hand, being short a Poisson factor is adding real (downside) risk.
Thus, we would expect the market price of risk for a Poisson factor to be negative. That is, if you are short
a Poisson factor (B is negative), then you should be rewarded for taking on that risk, and a negative market
price of risk would reflect that.
One can show this in a much more rigorous fashion, but for our purposes, let’s just note that λ < 0 for a
Poisson factor. I don’t like dealing with a negative quantity, so let’s define λ

= −λ and rewrite the absence
of arbitrage condition in terms of λ

as
A = Pλ
0
+Bλ (9.35)
= Pλ
0
+B(−λ

) (9.36)
= Pλ
0
−Bλ

(9.37)
where λ

> 0.
Now, we can substitute this into the tradables table to obtain
Prices

P

Changes
d

V

=
Factor Model


0
−Bλ


dt +

B

dπ(t; α)
(9.38)
Now, by the Poisson factor invariance under changes to the intensity, we can replace dπ(t; α) → dψ =
d˜ π(t; α + β). Let’s choose β = λ

− α so that dψ = d˜ π(t; λ

) (here is where it is important that λ

> 0, so
that it can be an intensity!), which leads to
Prices

P

Changes
d

V

=
Factor Model


0
−Bλ


dt +

B

d˜ π(t; λ

)
(9.39)
The final step is to compensate the Poisson process. That is, we subtract off the mean of the Poisson process
so that the random factor has mean zero.
Prices

P

Changes
d

V

=
Factor Model


0

dt +

B

(dπ(t; λ

) −λ

dt)
(9.40)
Since the random factor term now has zero mean, we can see that the drift of the value changes V for all
tradables is equal to the market price of time λ
0
. This was the same as in Brownian case.
Thus, for Poisson processes, we can replace the original Poisson factors by new Poisson factors with
different intensities so that the drift of all tradables is the market price of time λ
0
(don’t forget to subtract
off the mean of the Poisson factors so that they have zero mean!). This is the risk neutral representation
under Poisson factors!
Note that in this case, the new intensity of the factors in the risk neutral representation is equal to
(minus) the market price of risk! Let’s make this formal.
94 CHAPTER 9. THE ROAD TO RISK NEUTRALITY
(⋆) Risk Neutral Representation for Poissons: Let
Prices

P

Changes
d

V

=
Factor Model

A

dt +

B

dπ(t; α)
(9.41)
be a tradables table. Then, under arbitrage invariant substitutions of the factors dπ(t; α) → dψ = d˜ π(t; λ

),
the following tradable table will produce the same absence of arbitrage prices
Prices

P

Changes
d

V

=
Factor Model


0

dt +

B

(d˜ π(t; λ

) −λ

dt) .
(9.42)
Equation (9.42) is called the risk neutral representation because all tradables have a drift equal to the market
price of time, regardless of how risky they really are.
9.4 Pricing as an Expectation
The risk neutral representations lead to a powerful risk neutral pricing formula. This is because instead of
starting with the real tradables table, we can start with the risk neutral representation. The fact that the
drift of all tradables is equal to the market price of time leads us to a convenient new pricing formula. Let’s
see how it works for the Brownian case.
From the risk neutral representaion equation (9.32) we have
dV = λ
0
Pdt +Bd˜ z. (9.43)
Let’s assume that we are not dealing with a futures contract, so that V = P. Thus, we have
dP = λ
0
Pdt +Bd˜ z (9.44)
which is telling us that the drift of P is λ
0
when we use the factors based on d˜ z.
Now, via Ito’s lemma one can verify that
d

e

t
0
λ0(s)ds
P

= e

t
0
λ0(s)ds
Bd˜ z. (9.45)
Taking expectations of both sides gives
d
˜
E

e

t
0
λ0(s)ds
P

= 0 (9.46)
since ˜ z is a Brownian motion. (We also switched the d and the expectation.) Finally, integration of both
sides says that
P(0) =
˜
E

e

t
0
λ0(s)ds
P(t)

. (9.47)
We have arrived at risk neutral pricing.
(⋆) The Risk Neutral Pricing Principle: Absence of arbitrage prices are given by the formula
P(0) =
˜
E

e

t
0
λ0(s)ds
P(t)

(9.48)
where the expectation
˜
E(·) is taken under the risk neutral representation and λ
0
is the market price of time.
This risk neutral pricing principle applies in the Poisson case as well. Thus, this is a new pricing point
of view that follows from the factor approach! The presentation has been a little abstract to this point, so
let’s see how it would work in practice.
9.5. APPLICATIONS OF RISK NEUTRAL PRICING 95
9.5 Applications of Risk Neutral Pricing
Let’s see how the risk neutral pricing principle is used in a couple of familiar situations. But first, let’s
outline how it is applied.
9.5.1 How to Apply Risk Neutral Pricing
Risk neutral pricing is applied using the following steps.
1. Via an arbitrage invariant substitution of the factors, convert the tradables table to its risk neutral
representation.
2. Apply the Risk Neutral Pricing Formula to the derivative security that is being priced.
That is it! Let’s clarify with some examples.
9.5.2 Black-Scholes
Let’s see how risk neutral pricing applies to the Black-Scholes setup. Recall that the bond and stock follow
dB = r
0
Bdt (9.49)
dS = µSdt +σSdz (9.50)
dc = (c
t
+µSc
S
+
1
2
σ
2
S
2
c
SS
)dt +σSc
S
dz. (9.51)
Now, according to the risk neutral pricing principle, we have the same absence of arbitrage prices if we set
all the drifts to the risk free rate (market price of time). Hence, we have
dB = r
0
Bdt (9.52)
dS = r
0
Sdt +σSd˜ z (9.53)
dc = r
0
cdt +σSc
S
d˜ z. (9.54)
Now, applying the risk neutral pricing formula to the call option c(S, t) gives
c(S(0), 0) =
˜
E

e
−r0T
c(S(T), T)

. (9.55)
But, if T is expiration, then we know that c(S(T), T) = (S(T) −K)
+
, so the risk neutral pricing formula is
c(S(0), 0) = e
−r0T
˜
E

(S(T) −K)
+

(9.56)
where the e
−r0T
was pulled out of the expectation because it is not random.
The expectation
˜
E(·) is taken under the risk neutral representation (i.e. S(t) follows (9.53), etc.). Per-
forming this expectation leads to
d
1
=
ln(S/K) + (r
0
+
1
2
σ
2
)(T)
σ

T
(9.57)
d
2
= d
1
−σ

T (9.58)
c(S, 0) = SN(d
1
) −Ke
−r0T
N(d
2
) (9.59)
which is the Black-Scholes formula! Thus, we were able to obtain a pricing formula without resorting to
partial differential equations!
96 CHAPTER 9. THE ROAD TO RISK NEUTRALITY
9.5.3 Poisson Model
Let’s try it for a Poisson model of Section 6.1.4. To be consistent with the approach above in Section 9.3.2,
I won’t compensate the original Poisson factor dπ(t; ν) as was done in Section 6.1.4. The tradables table is

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
µS
c
t
+µSc
S
¸
¸
dt +

0
(k −1)S
c(kS

) −c(S

)
¸
¸
dπ(ν)
and the market price of time is λ
0
= r
0
while the market price of risk is
λ
1
=
µ −r
0
k −1
. (9.60)
For the risk neutral representation we use minus the market price of risk
λ

1
=
r
0
−µ
k −1
(9.61)
and the risk neutral representation is

B
S
c
¸
¸
d

B
S
c
¸
¸
=

r
0
B
r
0
S
r
0
c
¸
¸
dt +

0
(k −1)S
c(kS

) −c(S

)
¸
¸
(dπ(λ

1
) −λ

1
dt) . (9.62)
Finally, we can apply the risk neutral pricing formula
c(S(0), 0) =
˜
E

e
−r0T
c(S(T), T)

. (9.63)
But, if T is expiration, then we know that c(S(T), T) = (S(T) −K)
+
, so the risk neutral pricing formula is
c(S(0), 0) = e
−r0T
˜
E

(S(T) −K)
+

. (9.64)
where the e
−r0T
was pulled out of the expectation because it is not random. In the risk neutral representation,
(9.62) determines the expectation
˜
E(·). Thus, computing the expectation in (9.64) gives
c(S, t) = SΨ(x, y) −Ke
−r0(T)
Ψ(x, y/k) (9.65)
where
Ψ(α, β) =

¸
i=α
e
−β
β
i
i!
, y =
(r
0
−µ)kT
k −1
(9.66)
and x is the smallest non-negative integer greater than
ln(K/S)−µ(T)
ln(k)
.
9.5.4 HJM
Recall the HJM model of Section 7.2.3. In this model, the underlying variables are given by the instantaneous
forward rates
dr(t|s) = µ(t|s)dt +σ(t|s)dz(t). (9.67)
and the tradables are bonds that follow
dB(t|T) =

B(t|T)r(t|t) −B(t|T)

T
t
µ(t|s)ds +
1
2
B(t|T)

T
t

T
t
σ(t|s)σ(t|r)drds

dt

B(t|T)

T
t
σ(t|s)ds

dz
9.5. APPLICATIONS OF RISK NEUTRAL PRICING 97
If you recall from Section 7.2.3 this was extremely messy to deal with. So, let’s start over but with the risk
neutral perspective in mind.
Let’s start with the tradables that are the bonds. Since this is a single factor model, the risk neutral
representation under Brownians tells us that we may write the tradables in the form
dB(t|T) = r(t|t)B(t|T)dt +ν(t|T)B(t|T)d˜ z (9.68)
where d˜ z is the risk neutral factor and r(t|t) = r
0
(t) is the instantaneous short rate. Now, we can ask what
this implies about the instantaneous forward rates in the risk neutral world. Well, the relationship between
the bonds B(t|T) and the instantaneous forward rates is
r(t|T) = −

∂T
ln B(t|T). (9.69)
Then, by Ito’s lemma, we have
dr(t|T) =

∂T

1
2
ν
2
(t|T) −r(t|t)

dt −

∂T
ν(t|T)d˜ z (9.70)
=

∂T

1
2
ν
2
(t|T)

dt −

∂T
ν(t|T)d˜ z. (9.71)
If one lets
σ(t|T) = −

∂T
ν(t|T) (9.72)
then
µ(t|T) =

∂T

1
2
ν
2
(t|T)

= ν(t|T)

∂T
ν(t|T) = σ(t|T)

T
t
σ(t|s)ds (9.73)
where
dr(t|T) = µ(t|T)dt +σ(t|T)dz(t). (9.74)
These equations tell us that under the risk neutral representation, if we know the volatility of the instanta-
neous forward rates (σ(t|T)), then we can compute what the drift terms must be by equation (9.73).
Another way to get to this same result is to revisit the results of Section 7.2.3 equation (7.22) that said:
µ(t|T) −σ(t|T)

T
t
σ(t|s)ds = σ(t|T)λ
1
(9.75)
and note that in the risk neutral representation, we have a zero market price of risk λ
1
= 0 (because all
tradables earn the risk free rate). Thus, the above equation becomes
µ(t|T) = σ(t|T)

T
t
σ(t|s)ds (9.76)
which is what we were looking for.
Thus, if we want to use the risk neutral representation, we would first estimate the volatilities of the
instantaneous forward rates σ(t|T) from market data, then use (9.73) to compute the risk neutral drifts.
Once we have this, pricing proceeds via expectations as in the risk neutral pricing formula. In the
HJM model, the expectation is often computed by Monte Carlo. That is, one simulates the risk neutral
representation of the instantaneous forward rates. Then, one can compute the payoff value of a derivative,
and compute the expectation of it. This is the risk neutral priceing approach.
98 CHAPTER 9. THE ROAD TO RISK NEUTRALITY
9.5.5 Libor Market Model
The LMM model of Section 7.2.4 is also made quite simple by the use of risk neutrality. Recall that the
LMM is similar to the HJM model, but deals with forward rates between times T
i
and T
i+1
denoted by
R(t|T
i
, T
i+1
) and that are assumed to follow
dR(t|T
1
; T
2
) = a
1
R(t|T
1
; T
2
)dt +b
1
R(t|T
1
; T
2
)dz
2
. (9.77)
For notational simplicity, we write R
i
= R(t|T
i
, T
i+1
) with
dR
i
= a
i
R
i
dt +b
i
R
i
dz
i
. (9.78)
Recall from equation (7.46) that the calibration relationship on the underlying R
i
variables is
−λ
i−1

τb
i−1
R
i−1
(1 +τR
i−1
)

=

¸
τa
i
R
i
−τb
i
R
i
¸
i
j=1

τbjRj
(1+τRj)

ρ
ij
1 +τR
i
¸

. (9.79)
Now, we can switch to the risk neutral representation by setting all the market prices of risk to zero λ
i−1
= 0.
This reduces the above equation to
0 =

¸
τa
i
R
i
−τb
i
R
i
¸
i
j=1

τbjRj
(1+τRj)

ρ
ij
1 +τR
i
¸

(9.80)
or by simplifying further
τa
i
R
i
−τb
i
R
i
i
¸
j=1

τb
j
R
j
(1 +τR
j
)

ρ
ij
= 0 (9.81)
or finally
a
i
= b
i
i
¸
j=1

τb
j
R
j
(1 +τR
j
)

ρ
ij
(9.82)
which is quite a bit simplier than what we started with.
Note that this is similar to what we had in the HJM risk neutral model. We can use market data to
estimate the b
i
terms (the volatility of the forward rates), and then use equation (9.82) to obtain their drifts
in the risk neutral representation. Pricing is then done by expectation.
9.6 Summary
The point of this chapter was to show that risk neutral pricing is a logical consequence of the factor approach
to derivative pricing. The idea was that details of the factors do not seem to appear in the factor APT
equations that we used throughout the book. That gave us the idea that perhaps we could change the
factors (as long as we didn’t disturb the basic factor coefficient structure) and still arive at the same absense
of arbitrage price. By using a different set of factors (that still preserved the same absense of arbitrage
prices) in many case we can simplify our calculations of the absense of arbitrage prices. This is the basic
notion of risk neutral pricing. In fact, there is quite a bit more that one can do when the full power and
generality of the risk neutral approach is explored. But that, my friends, is the subject of another little
book...
9.7 Problems
Problem 9.7.1 Verify equation (9.45).
Problem 9.7.2 Verify equatin (9.70).
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[2] F. Black and M. Scholes. The pricing of options and corporate liabilities. Journal of Political Economy,
81:637–659, 1973.
[3] A. Brace, D. Gatarek, and M. Musiela. The market model of interest rate dynamics. Mathematical
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99
Index
APT, 32
Price Form, 35
Return Form, 32
Arbitrage
Price Implication, 35
Return Implication, 31
Black-Scholes, 49, 95
Formula, 95
Hedging, 80
Brownian Motion, 1
Increment, 3
Calibration, 47
Compound Poisson Process, 7
Cox-Ingersoll-Ross, 25
Delta, 79, 84
Delta Hedge, 84
Delta-Gamma Hedge, 85
Derivative, 42
Definition, 42
Dividends, 50
Factor Models
Via Ito’s Lemma, 43
Factors, 41
Futures
Derivative Pricing, 54
Gaussian Random Variable, 1
geometric Brownian Motion
Black-Scholes, 49
Greeks, 85
delta, 79, 85
gamma, 85
rho, 85
Taylor Expansion, 85
theta, 85
vega, 85
Heath-Jarrow-Morton, 66
Hedging, 77
Black-Scholes, 80
Delta, 84
Delta-Gamma, 85
Immunization, 80
Incomplete, 81
Immunization, 80
Implied Volatility, 86
Incomplete, 46, 81
Hedging, 81
intensity, 3
Ito’s Lemma
Obtaining Factor Models, 43
Jump Diffusion
Derivative Pricing, 55
Merton, 55
Libor-Market-Model, 69
Market
Incomplete, 46
Market Price of Risk, 33
Market Price of Time, 33
Marketed Tradables, 44
Merton, 55
Money Market Account, 63, 64
Dynamics, 64
Normal Random Variable, 1
Null Space, 32
Relation to Range Space, 32
Option
European Call, 43
Ornstein-Uhlenbeck, 24, 25
Perpendicular Space, 32
Poisson Process, 1, 3
Compound, 7
intensity, 3
Poisson Processes
Derivative Pricing, 53
Poisson Random Variable, 3
Price APT
100
INDEX 101
Application to Pricing, 44
Range Space, 32
Relation to Perp of Null Space, 32
Relative Pricing, 44
Risk Neutral, 89
Pricing, 95
Principle, 94
Risk Neutral Pricing
Risk Neutral Representation, 92, 94
Risk Neutral Representation, 92, 94
Short Rate, 64
Single Factor Models, 64
Vasicek, 64
Stochastic Process
Compound Poisson Process, 7
Tradables, 42
Marketed, 44
Tradables Table, 44
Underlying Variables, 41
Vasicek, 24, 64
Volatility
Implied, 86

2

Contents
1 Basic Building Blocks and Stochastic Differential Equation Models 1.1 Brownian Motion and Poisson Processes . . . . . . . . . . . . . . . . . . 1.1.1 Gaussian Random Variables . . . . . . . . . . . . . . . . . . . . . 1.1.2 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.3 Poisson Random Variables . . . . . . . . . . . . . . . . . . . . . . 1.1.4 Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.5 Increments of Brownian Motion and Poisson Processes . . . . . . 1.2 Stochastic Differential Equations . . . . . . . . . . . . . . . . . . . . . . 1.2.1 Differentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.2 The Differential . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.3 Compound Poisson Process . . . . . . . . . . . . . . . . . . . . . 1.2.4 Ito Stochastic differential equations . . . . . . . . . . . . . . . . . 1.2.5 Poisson Driven Differential Equations . . . . . . . . . . . . . . . 1.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Ito’s Lemma 2.1 Ito’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 The chain rule of ordinary calculus . . . . . . . . . . . . . . . 2.1.2 Ito’s lemma for Brownian motion . . . . . . . . . . . . . . . . 2.1.3 Replacing dz 2 by dt . . . . . . . . . . . . . . . . . . . . . . . 2.1.4 Discussion of Ito’s lemma . . . . . . . . . . . . . . . . . . . . 2.2 Ito’s lemma for Poisson Processes . . . . . . . . . . . . . . . . . . . . 2.2.1 Interpretation of Ito’s lemma for Poisson . . . . . . . . . . . . 2.3 More versions of Ito’s Lemma . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Ito’s Lemma for Compound Poisson Processes . . . . . . . . . 2.3.2 Ito’s Lemma for Brownian and Compound Poisson Processes 2.3.3 Ito’s Lemma for vector processes . . . . . . . . . . . . . . . . 2.4 Ito’s lemma, the product rule, and a rectangle . . . . . . . . . . . . . 2.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Standard Stochastic Differential Equations with Solutions 3.1 Geometric Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 Stock Price Interpretation . . . . . . . . . . . . . . . . . . . . 3.2 Geometric Poisson Motion . . . . . . . . . . . . . . . . . . . . . . . . 3.2.1 A conditional lognormal version of geometric Poisson Motion 3.3 A jump-diffusion model . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 A more general SDE . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 The Ornstein-Uhlenbeck Process and Mean Reversion . . . . i . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 1 1 3 3 3 5 5 6 7 7 8 9 10 11 11 11 12 13 14 14 15 16 16 16 16 17 18 19 21 21 21 22 23 23 23 24

. . . . . . . . . . . . 4. . 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1. . . . . . . . . . 4. . . . . . . . .4. . . . . . . . 6. . . . . .4 The Factor Approach using Price Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Pricing the Derivative . . . . . . . . . .5. . .2. . . . . . . . .6 Summary . . 4. . . . .6 Jump diffusion . . . . . . . . . 4. . . . . . . . .6 Three Step Procedure . . . . . . . . . . . . . . . . . . . . . . .3. . . . . . . . . . . . . . . . . .5 Options on Futures . . . . . . . . . . . . . . . . . . . . . . . . Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. . . . . . . . . . . . . . . .6 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Application of the Factor Form: Equity Derivatives 6. . . . . . . . . . . . . . . . . . . . . . 4. . . . . . . . . . . . . . . Problems . . . .5. . . . .1 Direct Factor Models . . . . 4. . . . . 5. . . . . . . . . . . . . . . . . . . . .1. .1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5.3. . . . .1 Stocks . . . . . . .2. . . . . . . . . 5. . . . . . . . . . . . . 5. . . . . . . . . . 4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Stochastic differential equations and factor models 4. . . . . . . . . . . . .5 A Problem with Returns . . . . . . . . . . . . . . . . . . . . . . .2 Underlying Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. . . . .7 CONTENTS Cox-Ingersoll-Ross Process . . . . . . . . . . . . 5.7 Exchange one asset for another . .4 A Derivative is a Tradable . . . . . . . . . . . . . . . . . . . . . . . . . . .3.2 Profit/Loss and Arbitrage .2 Factor Models via Ito’s Lemma . . . . .4 Poisson Processes . . . . . . . . . . . . . . . . 5. . . . . . . . 6. . . . . 4. . . .1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1. . . . . . . . . . . . . . . . . . . . . . .1 Examples from Equity Derivatives . . . . . . . . . . . . . . .3 Tradables . . . . . . . . . . . . . . . . . . . . . . . . . .2. . . . . . . . . . . . . . . . . . . . . . . . . . .1. . . . . . . . . . .1 Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 A Useful Absence of Arbitrage Condition . . .2 Futures contracts . . . . . . . . . . . . . 6. . . . . . . . . . . . . . 4. . . . . . . . . .2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Price Changes and Arbitrage . . . . . . . . . 4. . . .3. . . . . . . . . . . . . . . . . . . . 4. .7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. . . . . . . . . .3 The Factor Approach to Arbitrage using Returns . . . . . . . . . . .8 Problems . . .5 Two standard examples . . . . . . . . . . . . . .2 A Classification of Quantities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. .1 Returns . . . . . . . . . . . . . . . . . . . . . . . .4 Tradables tables . . . . . . . . . . . . . . . 6. 5. . . . . . . . . . . . . . . . . . . . . . . . . .3. . . . . . . . . . . .7 Problems . .1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.4 Interpretations . . . .5. . . . . . . . . . . . . . . .3 Underdetermined and Overdetermined Systems 5. . . . . . . . . 6. . . . . . .5. . . .2 Returns and Factors Models . . . . . . . . 5. . . . . . . . . . . . . . 25 26 27 29 29 29 29 30 31 31 32 32 33 34 34 34 34 36 36 37 37 38 41 41 41 41 41 42 42 43 43 43 44 44 44 45 45 47 48 48 49 49 49 50 52 53 54 55 57 4 The Factor Approach to Arbitrage Pricing 4. . . . . . . . . . . . . . . . 4. . . . . . . . . . . . .ii 3.2. . . . . . . . . . . . . . . . . . . . . . . 5. . . . . . . . . . . . . . . . . . . . . . .3. . .4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Arbitrage . . . . . . . . . . . . . . . . . . . . . . 4. . . . . . . . . .1 Introduction . . . . . . . . . . . 4. . . . . . . . . . . . . . . . . . . . . . . . 4. . . . . . . . . . . . . . . . . . . . . .3 Cash Dividends . . . . . . . . . . . . . . . . .3. . . . . . . . . . . . . . . . . . .3 Factor Models for Underlying Variables and Tradables 5. . . . . . . . . . . . . . . . . . . . . .1 The Factor Approach to Arbitrage Pricing . . . . .2 Null and Range Space Relationship .5 3.2 Dividend Paying Stocks . . . . . . . . . . . . . . 6. . . . . . . . . . . . . . . . . . . . . . . . . .1 Black-Scholes . . . . . . 5. . . . . . . . . . . . . . . . . . 5 Constructing a Factor Pricing Framework 5. . . . . . . . . . . . . . . . . . . . . . . . .5 Applying the Price APT . . . . . . . . . . . . .1 Relative Pricing and Marketed Tradables . . . . . .

. 7. . . . . . . . . . . . . . . . . . . . . . . . . . 7. 9. . . . . . . 9. . . . . . . .2 Poisson Factors . . . . iii 58 59 63 63 64 64 65 66 69 72 72 73 74 77 77 77 78 78 79 81 82 83 83 84 84 85 85 85 86 87 87 89 89 89 90 91 92 92 93 94 95 95 95 96 96 98 98 98 6. . . . 8. . . . . . . . . .3. . . . .1 Defaultable Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7. . . . . .3 Credit Derivatives .2 Multi-Factor Short Rate Models . . . . . . . .3 Heath-Jarrow-Morton . . . . . . . . . . .2. . . . .1 Brownian Factors . . . . . . .2 Do the Factors Matter? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Risk Neutral Representations . . . . . . . . . . . . . . . . . . . . . . .3. . . of Default . . . . . . . 9. . . .2. . . . . . . . . . .8 Stochastic volatility . 9. . . . . . . .4. . .1 The Greeks . . . . . . . . . . . . . . . . . . . . .5 Applications of Risk Neutral Pricing . .2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Hedging from a Factor Perspective . . . . 9. . .CONTENTS 6. . . . . . . . . . . . . . . .1 Single Factor Short Rate Models . . 7. . . . . . . . . . . . . . . . . . . . . .2 Black-Scholes . . . . . . . . . . .3. . . . . . . . . . . . . . . .3 Determining what the error looks like . . . . . . . . . . . . . . . . . . . . . . . . . . .2 A Delta-Gamma Hedge . . . . . . . . . . . . . . . . . . . . .1 Brownian Factors . . . . . . . . .5. . . . . . . . . . . . . . .2 7 Application of the Factor Form: Interest Rate and Credit Derivatives 7. . . . 8. . .4 Hedging under Incompleteness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. . . .2 Defaultable Bonds with Random Intensity 7. . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . .3 Derivatives imply Small Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. . . . . . . . . . . .3. . . . . . . . . . . . . . 7. . . . . . . . . . . . . . . . . . . . 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . 8. . . . . . . . . . . . . . . .5 A Question of Consistency . . . . . . . . . . . . . . .3 Poisson Model . . . . . . . . . . . . . . . . . .1 Introduction . . 8. . . . . . . . . . . . . . . . . . . . . . . . 7. . . . . . . . .5 Summary . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . .1 How to Apply Risk Neutral Pricing . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Summary . . . . . . . . . . . . . . . . . . . . .3 Hedging from an Underlying Variable Sensitivity Perspective 8. . . . . . . . . 8.3.2 Hedging Bonds . . .2. . . . 8. . . . . . . 8. . . . . . . . . . . . . . . . . . . . . . 8. . . . . . . .2 Poisson Factors . . . . . . . . . . . . . . . . . . . . . . . .5. . . . . . . .5. . . . . . . . .4 Pricing as an Expectation . . . . . . .4. . . . . . . . . . . . . . . . . .2. . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . .2 The Relationship Between Hedging and Arbitrage . . . . . . . . . . . . . . . . . . 7. . . 9 The Road to Risk Neutrality 9. . . . . . . . . . . .2 Interest Rate Derivatives . . . . . . . . . . . . . . . . . . 7. . . . . . . . . . . . . . .1 Description Using a Tradables Table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Problems . . . . . . . . .4. 9. . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8. . . . . . . . . . . . . . . . . 8 Hedging 8. . . . . .2. . . . . Problems . . . 9. . . . . . . . . . . . .1 Black-Scholes Hedging . .4 The LIBOR Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8. . . . . . . . . . . . .3. . . . . . . . .2. . . . . . . . . .1.3. . . . . . . . . . . .5 Libor Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 HJM . . . . . . . . . . . . . 8. . . . . . . . . . . . . . . . . . . . . .1 Introduction . 9. . . . . . . .2. . . . . . . . . .1 Notation and the Money Market Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Higher Order Approximations . . . . . 9. . . . . .3 Hedging Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5. . . .7 Problems . . . . . . 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5. . . . 8. . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . .

iv CONTENTS .

∞).market price of risk.the transpose of a vector x.spot rate for time T − t at the current time t. • B0 (t) . • x− . • r0 (t) . v . • R+ . • f (t|T ) .time t swap rate for swap dates {Ti }.time t forward price for contract with delivery at time T . • r . • λ .the transpose of a matrix A. • St • Sx • Sxx ∂S ∂t Partial derivative of S with respect to t.forward interest rate between time T1 and T2 at time t.Poisson Process with intensity λ. λ) .a constant risk free rate of interest (when allowed to be a function of time.Stock price at time t. • F (t|T ) .a vector of returns.notation for limit from the left: x(t−). T2 ) .the real line (−∞. • AT . Second partial derivative of S with respect to t. T2 ) . Partial derivative of S with respect to x. ∞).the time t value of the money market account.the nonegative real line [0. ∂S ∂x 2 ∂ S ∂x2 • z(t) .the instantaneous forward rate at time t between times s and s + ds. • S(t|{Ti }) . see the short rate process below).limit from the left: x(t−) = limh↑t x(h).time t price of a zero coupon bond with maturity T and face value $1 at time t • B(t|T1 . • x(t−) .time t forward price of a zero coupon bond with maturity T2 and face value $1 when delivery of the forward contract is at time T1 . • π(t.the instantaneous short rate process at time t. • B(t|T ) . • S(t).Notation • R . • R(t|T ) . • r0 . • r(t|s) . • xT .time t futures price for contract with delivery at time T .Brownian motion. • R(t|T1 .

vi CONTENTS .

then you have received a powerful tool to add to your toolbox for problem solving. . . 1 .3) 1.2) (1. We provide building blocks for modeling assets in the form of Brownian motion and Poisson processes.1 Gaussian Random Variables 1 (2π)n/2 |Σ|1/2 1 exp − (x − µ)T Σ−1 (x − µ) 2 An n-dimensional Gaussian (Normal) random variable is a random variable with density function: X ∼ fX (x) = (1.1. z(tn ) − z(tn−1 ) are independent for t1 ≤ t2 ≤ · · · ≤ tn . . 1. With these two building blocks we create more complicated models by using Brownian motion and Poisson processes to drive differential equations (which are then known as stochastic differential equations). A real-valued stochastic process z(t) : t ∈ R+ is a Brownian Motion if: 1. 1.1) where µ ∈ Rn is the mean and Σ ∈ Rn×n is the covariance matrix: µ = E[X]. z(t) − z(s) ∼ N (0.1 Brownian Motion and Poisson Processes Brownian motion and Poisson processes are our fundamental building blocks for creating models of asset prices. z(t2 ) − z(t1 ). 3. The key features are that Brownian motion has continuous sample paths (with probability 1). Σ = E[(X − µ)(X − µ)T ]. don’t let that fool you. z(0) = 0.1. The presentation here is tutorial and heuristic. However. (1. and Poisson processes jump! We begin with Brownian motion which is built on the Gaussian random variable. If you gain intuition from it. 2.Chapter 1 Basic Building Blocks and Stochastic Differential Equation Models This chapter contains an introduction to the basic mathematics required for derivative pricing and financial engineering. z(t3 ) − z(t2 ).2 Brownian Motion Brownian motion (also known as a Wiener Processes) is a stochastic process built upon the Gaussian random variable as follows. . t − s) for t > s.

2CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS You should remember the following facts about Brownian motion, as they make Brownian motion an ideal building block for unpredictable but continuous asset price movements: • There exists a version of Brownian motion that has continuous sample paths. • Brownian motion is nowhere differentiable with probability 1. The first property says that Brownian motion is appropriate for price processes that don’t jump. In many cases, price processes do jump, hence we will need to introduce the Poisson process next to model jumps. The second property can be interpreted in the context of predictability. If a curve is differentiable at a point, then that means that locally it can be approximated by a line, with the slope of the line being the derivative of the curve at that point. But this means that we can predict (to order dt) the future value of the curve. In finance, we often want to assume that we cannot predict future prices. Non-differentiability indicates that in the sense mentioned above, future prices are not predictable. Therefore, Brownian motion is an ideal building block upon which to build asset price processes. A sample path of Brownian motion is given in Figure 1.1.
Sample Path of Brownian Motion 0.4

0.2

0

−0.2 z(t) −0.4 −0.6 −0.8 −1 0

0.2

0.4 time

0.6

0.8

1

Figure 1.1: A typical sample path of Brownian motion. Just as there are vector Gaussian random variables, we can define a vector Brownian motion as follows. A vector Brownian motion z(t) ∈ Rn with covariance structure Σ ∈ Rn×n is a stochastic process satisfying 1. z(0) = 0. 2. z(t) − z(s) ∼ N (0, Σ(t − s)) for t > s. 3. z(t2 ) − z(t1 ), z(t3 ) − z(t2 ), . . . , z(tn ) − z(tn−1 ) are independent for t1 ≤ t2 ≤ · · · ≤ tn . Thus a vector Brownian motion is build upon the vector Gaussian random variable.

1.1. BROWNIAN MOTION AND POISSON PROCESSES

3

Brownian motion has continuous sample paths. That is too well behaved for some events we would like to model. For instance, market crashes, bankruptcy, etc. are often discontinuous price movements. Hence, we need a process that jumps! Poisson processes, which are built on the Poisson random variable, are what we are looking for.

1.1.3

Poisson Random Variables
λk exp(−λ) k!

A discrete random variable X taking values in the whole numbers is Poisson with parameter λ > 0 if P (X = k) = k = 0, 1, ... (1.4)

The mean of a Poisson random variable is E[X] = λ and the variance is V ar(X) = λ.

1.1.4

Poisson Process

A Poisson process is a stochastic process built on Poisson random variables as follows. A Poisson process with parameter (intensity) λ is a stochastic process π(t; λ) : t ∈ R+ that satisfies 1. π(0) = 0. 2. π(t) − π(s) is Poisson distributed with parameter λ(t − s) for t > s. 3. π(t2 ) − π(t1 ), π(t3 ) − π(t2 ), . . . , π(tn ) − π(tn−1 ) are independent for t1 ≤ t2 ≤ · · · ≤ tn . For us, the most important property of Poisson processes is that they jump! Hence, they are good models for market crashes, jumps, bankruptcy, and other unexpected discontinuous price movements. A typical sample path from a Poisson process with intensity λ = 1 is given in Figure 1.2. The parameter λ is often called the intensity (or sometimes the propensity) of the Poisson process. You can think of it as the expected number of jumps in a single time period. Alternatively, you expect to see a 1 single jump every λ time periods. Therefore, the larger the intensity, the more frequent the jumps. We will assume that a Poisson process is continuous from the right, and not the left. That is, at the exact time that a Poisson process jumps, it takes on the new value that it jumped to. Functions that are right-continuous and have left-limits are called rcll functions (or cadlag or R-functions, etc). In a Poisson process, it is important to remember that at a jump time it takes on the new value, thus making sample paths of a Poisson process rcll functions.

1.1.5

Increments of Brownian Motion and Poisson Processes

Here are the intuitive pictures that I keep in mind when thinking of Brownian motion and Poisson Processes. Over a small ∆t Brownian motion and Poisson Processes can be thought of in simple and intuitive ways. We intuitively think of ∆t as a small increment in t. When dealing with a stochastic process X(t), we will also think of ∆X(t) as the change the occurs in X over a small time period ∆t. That is ∆X(t) = X(t + ∆t) − X(t). (1.5)

This notion of an increment of a stochastic process will guide our intuition. In this way, we can look at increments of Brownian motion and Poisson processes. Brownian Motion Over a small time ∆t, Brownian motion looks like ∆z(t) = z(t + ∆t) − z(t) ∼ N (0, ∆t) (1.6)

4CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS
Sample Path of a Poisson Processes with Intensity 1 5 4.5 4 3.5 3 π(t) 2.5 2 1.5 1 0.5 0 0 1 2 time 3 4 5

Figure 1.2: A typical sample path of a Poisson process. or, written slightly differently

√ ∆z(t) = ǫ ∆t

where ǫ ∼ N (0, 1)

(1.7)

where this follows from the second defining property of Brownian motion. That is, a Brownian motion √ differential looks like a standard Gaussian multiplied by ∆t. Thus, we will often use E[∆z] = 0 and E[(∆z)2 ] = ∆t. An even simpler picture arises from a binary approximation √ √∆t w.p. 1/2 ∆z ≈ (1.8) − ∆t w.p. 1/2 where w.p. stands for ”with probability”. This is depicted in figure 1.3.

Figure 1.3: Binary model of an increment in Brownian motion .

λ) = π(t + ∆t. we see that in a Brownian motion the size of the move scales with the square root of ∆t. Note that for a Poisson process. λ) = X A binary approximation to a Poisson process is ∆π(λ) ≈ 1 w. the probability of having a jump of size 1 scales with ∆t and is small if ∆t is small. ∆π is either 0 or 1 to order ∆t. On the other hand. 1.12) has a problem when it comes to processes that jump that are assumed to be right continuous. . Over ∆t it is ∆π(t.2. to avoid the technicalities of stochastic calculus. Poisson processes jump when they move. note the key difference between a Brownian motion and a Poisson process. We will use this point of view here. in a Poisson process. (1.2 Stochastic Differential Equations A simple way to think of a stochastic differential equation is as a differential equation that is driven by a stochastic process.4. the notion of a differential or infinitesimal of a process is the idea that in an increment ∆X(t) = X(t + ∆t) − X(t) we can take ∆t to be infinitesimally small. This is the essential difference between Brownian motion and the Poisson process.9) (1. The Poisson process is a good example. STOCHASTIC DIFFERENTIAL EQUATIONS Poisson Process A Poisson Process can also be approximated over a small time period ∆t. On the other hand. However.10) A simple picture of this heuristic increment model is given in Figure 1. λ∆t 1 − λ∆t where X ∼ P oisson(λ∆t).1 Differentials Roughly speaking.1.4: Binary model of an increment of a Poisson process. 0 w.p.12) (1. λ) − π(t. Hence over short periods of time the move in a Brownian motion is also small. from the binary model we see that the move size can always be 1.2. 1. From the simple binary model approximations. we will present a simple intuitive approach to stochastic differential equations and stochastic differentials. Also.11) where dt is ”just a little bit of t”. This is why Brownian motion has continuous paths. Thus. Figure 1. 5 (1.p. Over small periods of time the probability of a jump is also small. Thus. to quote Gillespie [8]. In such a case we would write dX(t) = X(t + dt) − X(t) (1. regardless of how small ∆t is.

That is π(t) = 0.5: A jump at time s. By using the limit from the left. and all other processes with jumps.5. Now.13). Since this is our convention. Figure 1. we are guaranteed never to capture the jump! This is purely a problem that arises from our convention to assume that Poisson processes are right continuous. Hence. we need to adjust our notion of a differential of a stochastic process slightly to account for our convention. That is π(s) = 1. we make sure to capture jumps of the process. the Poisson process jumps to 1. lim π(h) = π(s) (1. so intuitively we should have dπ(s) = 1. If we had assumed left continuity. now let’s consider defining the differential of a Poisson process as dπ(t) = π(t + dt) − π(t) (1. we should think of the following where X(t−) = limh↑t X(h) is the limit from the left of X at time t. Therefore.14) where dt > 0. Our convention will be to assume that at the exact time of the jump. assume that a jump occurs at time s. it is common in the literature to assume processes are right continuous. will be continuous from the right. Poisson processes. we know that a jump occurred at time s. then we wouldn’t have any problem. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS The Problem with Jumps We have to be very careful when a process has jumps and we assume right continuity of paths. This means that for us. and then when we add dt to the current time. 1. . no matter how small dt is made. Hence. However. so we have adopted this convention. However. Assume that a Poisson process is currently at 0.2.6CHAPTER 1. let us take the limit of dπ(t) for any t (including s) as dt ↓ 0. Here is the problem. Now. we are implicitly taking the limit from the right.13) h↓s A picture of this situation is shown in Figure 1.16) The solution to the above problem is that for a differential.15) where this calculation followed by right continuity as defined by equation (1. We obtain dt↓0 lim dπ(t) = lim π(t + dt) − π(t) = π(t) − π(t) = 0 dt↓0 (1. But this indicates that π never jumps! Something must be wrong!! What is wrong is that we have assumed that π is right continuous.2 The Differential dX(t) = X(t + dt) − X(t−) (1.

This process can be written as π(t. Hence.22) For this reason. λ).4. λ) iid copies of Y . 1 − λdt (1. etc. .. we should think of differentials as dπ(t.18) in order to make sure that we capture jumps. we represent the differential form of a compound Poisson process by Y dπ(t.6.2. where π(t. STOCHASTIC DIFFERENTIAL EQUATIONS 7 We will develop this point of view (which unfortunately can’t be made rigorous.4 Ito Stochastic differential equations Stochastic integrals can be defined in different ways. (1.1. λ). Y2 at time t2 . λ) be a Poisson process with jump times t1 . sums of them will limit as Brownian motion or a Poisson process.20) 1. we may write dπ Y = Y dπ. (1. The most useful for us is the Ito stochastic integral. by assigning jump Y1 at time t1 . z(t−) = z(t). are iid random variables.. λ) = i=0 Yi = 0 Ys dπ(s. 1/2 and dπ(λ) ≈ 1 w. λdt 1 − λdt (1.p. but merely provide the intuition that you should take away when considering stochastic differential equations. Let π(t.17) Note that since Brownian motion has continuous sample paths.23) Following along the lines of the binary approximation to a Poisson process as in Figure 1. w. λdt . at time t it is the sum of π(t.. I will not delve into the depths of the stochastic integral (because often people are never able to return!). Those binary models provide the proper intuition. λ) = i=0 Y Yi . for a Poisson process. λ).10).p.4.21) That is. Construct a new process π Y (t. but provides the proper intuition).. π(t. 0 w. λ) ∼ P oisson(λdt) (1. and in both cases. Processes of this form can also conveniently be written as integrals. λ) − π(t−. . dt). Don’t forget that we also have the binary model approximations of Figures 1. where Y1 .8) and (1. t2 . with Brownian motion we would have: dz(t) = z(t + dt) − z(t) ∼ N (0.3 and 1. However. giving √ √dt w. 1..24) and a heuristic infinitesimal picture of this is given in Figure 1.p. That is. 1/2 (1. Y2 . (1. λ) = π(t + dt. we simply replace ∆t by dt in (1. an infinitesimal model of a compound Poisson process can be thought of as Y dπ(λ) ≈ Yi 0 w.2. We can generalize this and allow them to jump randomly. reviewing from above.2.p.p. λ) is a standard Poisson process. they jump up by 1. For the differential. At this point.p. . (1.3 Compound Poisson Process When Poisson processes jump.19) dz ≈ − dt w.λ) t π Y (t.λ) π (t.

t)dt + b(x(t).27) (1. t) determines the instantaneous drift.) We will interpret this equation as follows: x(t + dt) − x(t) = a(x(t). t) as related to the instantaneous drift and b(x(t). t) determines the instantaneous variance of x. (1. A stochastic differential equation will be written as: dx(t) = a(x(t). t) as related to the instantaneous volatility as follows: E[dx|x(t)] = = = E[a(x(t). t) and b(x(t). We will assume that a and b are left continuous in the t .6: Infinitesimal model of a compound Poisson process. and a(x(t). λ) (1. (1.32) b2 (x(t).8CHAPTER 1. 1. t)dt)2 |x(t)] = = = E[b(x(t). This is important! It allows us to do the following simple calculations of the instantaneous drift and variance.26) Since z(t) has independent increments.31) (1. Instantaneous Drift and Variance We can interpret a(x(t). (At this stage. t)dt + b(x(t−). t)dt Hence.28) (1. That is. t)dt + b(x(t).33) where note that we have written x(t−) in the arguments of a and b. t)(z(t + dt) − z(t)). BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS Figure 1. t) are evaluated at time t.2.5 Poisson Driven Differential Equations We can also drive a differential equation by a Poisson process dx(t) = a(x(t−). they are independent of dz(t) = z(t + dt) − z(t). t)2 dz(t)2 |x(t)] b2 (x(t). a(x(t). t)E[dz(t)|x(t)] a(x(t). t)dz(t) (1. On the other hand. t)dz(t)|x(t)] a(x(t). we can compute the instantaneous variance of x as follows E[(dx − a(x(t). t)dt. b2 (x(t). x(t−) is the limit from the left at time t. t)Y dπ(t. I will ignore the technical conditions that must be placed on a and b in order to make such an equation well defined.30) (1. By x(t−) we mean x(t−) = limh↓0 x(t−h). t)dt + b(x(t). it is being driven by Brownian motion z(t). t)dt + b(x(t). t)E[dz(t)2 |x(t)] (1.29) Therefore.25) where in this case.

1.3. SUMMARY

9

argument so that we may use t instead of t− in the second argument of a and b. We will also sometimes use the notation x− when we want to suppress the argument t, or even a− when suppressing the arguments of a. The reason for using limits from the left is that in a Poisson process, we interpret our differential as dπ(t) = π(t + dt) − π(t−) and for the Ito integral, we assume that the coefficients a and b are evaluated at the point in time that the differential starts from. This is t−. This limit from the left is also important in a and b because we want a and b to be independent of dπ. The only way we can do this is to make sure that we use left limits. Note that this means that if π(t) jumps at time t, which also causes a jump in x at time t, we evaluate x(t−) in a and b which immediately preceeds the jump. With that established, once again, we can compute the instantaneous mean and variance: E[dx(t)|x(t−)] = = = E[a(x(t−), t)dt + b(x(t−), t)Y dπ(t)|x(t−)] a(x(t−), t)dt + b(x(t−), t)E[Y dπ(t)|x(t−)] a(x(t−), t)dt + b(x(t−), t)E[Y ]λdt (1.34) (1.35) (1.36)

Hence, in this case, the dπ(t) term can contribute to the instantaneous mean. This can make things messy! It is often nicer to think of the first term as the ”mean” term, and the second as the ”risk” term. To do this, we would like the second term to have zero instantaneous mean. Hence, we will often ”compensate” the Poisson process to give it zero mean. This is done by simply subtracting off the instantaneous mean from the second term and adding it to the first. dx(t) = (a(x(t−), t) + b(x(t−), t)E[Y ]λ)dt + b(x(t−), t)(Y dπ(t) − E[Y ]λdt) Then we can also compute the instantaneous variance: E[(dx(t) − (a(x(t−), t) + b(x(t−), t)E[Y ]λ)dt)2 |x(t−)] (1.37)

= b2 (x(t−), t)V ar(Y dπ(t))

= E[b2 (x(t−), t)(Y dπ(t) − E[Y ]λdt)2 |x(t−)]

= b2 (x(t−), t)E[Y 2 ]λdt + O(dt2 )

= b2 (x(t−), t)(E[Y 2 ](λdt + λ2 dt2 ) − E[Y ]2 λ2 dt2 )

= b2 (x(t−), t)(E[Y 2 ]E[dπ(t)2 ] − E[Y ]2 λ2 dt2 )

= b2 (x(t−), t)(E[Y 2 dπ(t)2 ) − E[Y ]2 E[dπ(t)]2 )

Hence, to order dt, the instantaneous variance is given by b2 (x(t−), t)E[Y 2 ]λ.

1.3

Summary

Brownian motion (built upon the Gaussian random variable) and the Poisson Process (built upon the Poisson random variable) are the basic building blocks used to create models of prices. In particular, we use these two processes to drive differential equations and that will allow us to capture a wide range of price phenomena. Due to the continuity of Brownian motion, it is good for modeling price paths and variables that do not jump. On the other hand, Poisson processes are an essential building block for modeling jumps in price processes or variables. Much intuition can be gained from simple ”incremental” and ”differential” models of processes and stochastic differential equations. The simple binary approximations to Brownian motion and Poisson processes are enough to correctly guide your intuition in the vast majority of cases. Thus, for modeling purposes, make sure you have a solid understanding of these two building block processes.

10CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS

1.4

Problems
dπ = 1 wp. 0 wp. λdt 1 − λdt (1.38)

Problem 1.4.1 Verify that our infinitesimal model of a Poisson process over small time dt:

has a mean and variance that agree with a Poisson random variable with parameter λdt to order dt. Problem 1.4.2 Poisson Processes Consider the time interval [0, 1]. Chop this time interval into n parts of equal length. Over each interval define the independent and identically distributed random variables Xi where Xi = Let Y =
i=1

1 w.p. 0 w.p.
n

λ/n 1 − λ/n Xi

(1.39)

(1.40)

(a) What is P r(Y = 0)? (b) In your answer in (a), take the limit as n → ∞. What do you get? (b) What is P r(Y = 1)? (c) Again take the limit. What is your answer? (d) Now consider an arbitrary but fixed k with k < n. What is P r(Y = k). (e) Again take the limit as n → ∞, and show that this converges to the Poisson random variable. (You √ 1 will probably want to use Stirling’s formula n! ∼ 2πe−n nn+ 2 . This calculation is a bit tricky!) (Note: In this problem we converge to a Poisson random variable with parameter λ since we took the time interval to be 1. If the time interval is t, we will converge to a Poisson random variable with parameter λt. As a function of t, we arrive at a Poisson process.) Problem 1.4.3 Poisson Processes again. Consider the following Markov chain. Let the state space be the whole numbers x = 0, 1, 2, .... Consider the following transition probabilities over the time instant dt: P r(x(t + dt) = n|x(t) = n) P r(x(t + dt) = n + 1|x(t) = n) Let pn (t) = P r(x(t) = n). (a) Write down a differential equation for p0 (t). (hint: to derive a differential equation, consider the amount of probability that flows into and out of the state x = 0 over time dt.) (b) Assume p0 (0) = 1 (that is, at time zero, x = 0 with probability 1). Solve the differential equation for p0 (t). (c) Derive a differential equation for pn (t), n > 0. Given your answer in (a), solve for p1 (t). Explain how you could solve for pn (t) for any n. (Note: again we have arrived at a Poisson process, but this time through Markov chain theory. A Poisson process is an example of a continuous time Markov process, and the set of differential equations you derived is the ”forward equation” for this process.) = = λdt 1 − λdt (1.41) (1.42)

Chapter 2

Ito’s Lemma
2.1 Ito’s Lemma

Ito’s lemma is the chain rule for stochastic calculus. In this chapter we present Ito’s lemma for Brownian motion and Poisson processes. It has been said that all of math finance can be done with just the knowledge of Ito’s lemma. To you, this means that you should make sure that you know (and understand) Ito’s lemma. In what follows, we will present versions of Ito’s lemma for Brownian motion and Poisson processes.

2.1.1

The chain rule of ordinary calculus

In ordinary calculus, here is how the chain rule works in conjunction with a differential equation. Let x(t) follow the differential equation dx = a(x, t). (2.1) dt Now consider a function of x(t) and t. Let’s call this function f (x(t), t). Assuming that f is differentiable, we can ask what the derivative of f is. To calculate it, we simply apply the chain rule df (x, t) ∂f dx ∂f dx = + = fx + ft dt ∂x dt ∂t dt where we are using the notation fx =
∂f ∂x

(2.2)
dx dt

and ft =

∂f ∂t .

Finally, we can substitute in for

from (2.1), giving (2.3)

df (x, t) ∂f ∂f = a(x, t) + = a(x, t)fx + ft . dt ∂x ∂t

This is a fairly straightforward calculation. However, when dealing with stochastic differential equations, the simple chain rule of ordinary calculus does not work. The reason is simple. Brownian motion is not differentiable so we can’t really take its derivative or the derivative of any function of Brownian motion. Also, Poisson processes jump, and at these jumps it is not even continuous, let alone differentiable. Thus, for stochastic differential equations we need to develop the correct mathematics for dealing with a function of a variable that follows a stochastic differential equation. The guiding result is known as Ito’s lemma. Multivariables Taylor Series Expansions Before diving into Ito’s lemma, you should make sure that you recall your multivariables Taylor series expansions to second order. This is extremely important! Ito’s lemma for Brownian motion is basically just a modified Taylor expansion to second order. So, let’s recall up to second order, the Taylor series expansion 11

. . . t) − f (x0 . 2 (2. t) 1 1 = ft dt + fx dx + ftt (dt)2 + fxx (dx)2 + fxt dxdt + . . . t) around a point (x0 . 2 2 (2.6) (or (2. so that a Taylor series expansion is df = 1 1 ft dt + fx dx + ftt dt2 + fxt dxdt + fxx dx2 + . f (x. . .. ITO’S LEMMA f (x0 . t0 )(t − t0 )2 + fxt (x0 . t0 ). t)dt + b(x. df = f (x(t + dt). fx .. . t0 )(x − x0 )(t − t0 ) + fxx (x0 . Hence. = . . . Consider writing the Taylor expansion of df . If that sounds simple..7) (2.  . (⋆) Ito’s Lemma for Brownian Motion: Consider the stochastic differential equation (SDE) dx = a(x. and df = f (x. . t0 ). In the multivariable case when x ∈ Rn .5) Now.. t)fx + b2 (x. the sum of the diagonal elements).2 Ito’s lemma for Brownian motion Given the differential of x(t).  fx1 xn  . t) = CHAPTER 2. fxn xn (2. 2 2 . . . .8) A useful trick in the multivariable case is to note that dxT fxx dx = T r(dxT fxx dx) = T r(fxx dxdxT ) (2. t) be a twice continuously differentiable function of x and t.4) (2. t + dt) − f (x(t). the Taylor series expansion is df where fx = [fx1 .. fxn x1  . and then throwing away terms of order higher than dt. fxx 1 1 = ft dt + fx dx + ftt dt2 + dxT fxt dt + dxT fxx dx + ..6) and the arguments of ft . t0 )(x − x0 ) 1 1 + ftt (x0 . Operationally. t0 )(t − t0 ) + fx (x0 . t) = (ft + a(x. then you are right. Ito’s lemma allows us to compute the differential of a function of x(t) and t. we will typically denote dx = x − x0 . t)fx dz. The following result is Ito’s lemma when x(t) is a process governed by a stochastic differential equation driven by Brownian motion. 2 2 (2.11) (2.e. Let’s see how it works in more detail. t0 )(x − x0 )2 + . interpreting terms such as dz 2 .9) where T r(·) is the Trace of a matrix (i. t)fxx )dt + b(x. t0 ) + ft (x0 . Then 1 df (x. 2 2 fx1 x1  ..10) ”Heuristic Proof”: I will suppress the arguments of a and b for convenience. 2. fxn ].12 of a function f (x. t)dz and let f (x.1. Ito’s lemma for Brownian motion boils down to nothing more than substituting dx = adt + bdz in the Taylor expansion of (2. it is the ”chain rule” for stochastic differential equations.. .. have been supressed. .7) in the multivariable case) for dx. dt = t − t0 .

then by integrating we would have T T dz 2 = 0 0 dt = T. we think of dz as being of order dt1/2 and only keep terms up to order dt yielding df = 1 ft dt + fx adt + fx bdz + fxx b2 dz 2 . 2 2. let’s first compute the mean of S(T.16) .. we will substitute in for dx using dx = adt + bdz which gives df = = 1 1 ft dt + fx (adt + bdz) + ftt (dt)2 + fxx (adt + bdz)2 + fxt (adt + bdz)dt + . Let’s approximate the integral above by the sum T ∆t −1 T S(T. then S(T. Let’s see why this was a reasonable thing to do .1. ∆t) = V ar  i=0 (z((i + 1)∆t) − z(i∆t)) 2 = i=0 V ar((z((i + 1)∆t) − z(i∆t))2 ). (2.3 Replacing dz 2 by dt Here is a simple argument as to why it is reasonable to replace dz 2 by dt. ∆t)] = E  i=0 (z((i + 1)∆t) − z(i∆t)) 2  T ∆t −1 T ∆t −1 = i=0 E (z((i + 1)∆t) − z(i∆t)) 2 = i=0 ∆t = T. ∆t) is a random variable since it involves z(t). ∆t): T ∆t −1 E[S(T. ∆t) → T . the claim is that as ∆t → 0.1. This does the trick. ∆t) converges to the constant T . ∆t) = i=0 (z((i + 1)∆t) − z(i∆t))2 ≈ dz 2 . Computing the variance: Now let’s compute the variance of S(T. 2 Finally we replace dz 2 by it’s expectation dt which leads to Ito’s lemma 1 df = (ft + afx + b2 fxx )dt + bfx dz.12) 2. and only keep terms up to order dt using the following logic. If we can say that dz 2 = dt. (2. the mean is T . The most glaring was replacing dz 2 by its expectation dt. 2 2 13 Now we take a crucial step. By independent increments T  T ∆t −1 ∆t −1 V ar(S(T ). ITO’S LEMMA Next.. let us see if this makes sense. since a random variable with zero variance must be a constant equal to it’s mean. ∆t). 2 2 1 1 2 ft dt + fx adt + fx bdz + ftt (dt) + fxx (a2 dt2 + 2abdtdz + b2 dz 2 ) + fxt (adt2 + bdzdt) + . or L2 (P ).13) Hence.. The standard √ deviation of dz is of order dt. ∆t) is equal to T .) Computing the mean: Okay.. Hence. (When we show that the variance approaches zero. To do this. (2. we will show that the mean of S(T.2.15) Hence. 0 (2. we are proving convergence in mean square. and its variance approaches zero. In this ”derivation” there were a couple of dubious steps. we are trying to show that the random variable S(T. Therefore.14) Now. (2. But note that S(T.....

(The key difference is that Poisson processes have sample paths of finite variation.18) (2.) . It is quick. the limit of the variance of S(T. (2.1. and jumps around like order dt1/2 . is quick and jumpy.17) Hence. the dz term is like the hare. Note that the above argument has much of the flavor of the weak law of large numbers. That means that the limit (in L2 (P )) is a constant and equal to the mean T . the deterministic dt drift term is like the tortoise. and this allows us to define the stochastic integral pathwise. I appeal to the wisdom of Gillespie [8]. V ar(S(T. The hare. Now your asking. starts the race and steadily works his way toward the finish line. but now that we are dealing with stochastic processes. As the story goes. But its direction is random. fx = x . Example 2. He gave the following explanation. we kept terms up to order dt in the Taylor expansion. In Ito’s lemma. In the end of the story. backwards. but runs forward and backwards and easily gets off track. ”What does this have to do with Ito’s lemma and stochastic differential equations?” Well. we have T ∆t −1 T ∆t −1 E[(z((i + 1)∆t) − z(i∆t))4 ] − E[(z((i + 1)∆t) − z(i∆t))2 ]2 3(∆t)2 − (∆t)2 2(∆t)2 . Some of the time it jumps forward and other times. This means that moves in dz are usually much larger than dt. according to Ito’s lemma. on the other hand. we have V ar((z((i + 1)∆t) − z(i∆t))2 ) = = = Therefore as ∆t → 0. Then. which is based on the story of the tortoise and the hare.1 Let dx = axdt + bxdz and consider f (x) = ln(x). I will leave you with the following thoughts.19) 1 1 where we have used that ft = 0. Why doesn’t this dz term completely dominate and even allow us to ignore terms of order dt? Again. We are used to doing things like this from ordinary calculus. He is much faster than the hare. the tortoise wins the race. It marches forward at a constant dt rate. ITO’S LEMMA But since z((i + 1)∆t) − z(i∆t) is Gaussian with mean zero and variance ∆t. ∆t)) = i=0 V ar((z((i + 1)∆t) − z(i∆t)) ) = 2 i=0 2(∆t)2 = 2T ∆t → 0. Together. 2. both the dt and dz terms contribute to the stochastic differential equation and neither term is guaranteed to dominate. we might question this step. the standard deviation of dz is dt1/2 . The tortoise being slow. Ito’s lemma in this case is merely an application of the Lebesgue-Stieljies calculus. the tortoise and the hare race each other. ∆t) is zero.2 Ito’s lemma for Poisson Processes Ito’s lemma for Brownian motion is more subtle that Ito’s lemma for Poisson Processes.1. Let’s see an example of Ito’s lemma applied to so-called geometric Brownian motion. This is the essential argument that allows us to use dz 2 = dt and a simplified version of the argument behind a real derivation of Ito’s lemma.4 Discussion of Ito’s lemma At the risk of overdoing an attempt to provide intuition behind Ito’s lemma. Hence. f (x) satisfies df = = 1 (ft + axfx + b2 x2 fxx )dt + bxfx dz 2 1 2 (a − b )dt + bdz 2 (2. just like we don’t know whether the tortoise or the hare will win the race! 2.14 CHAPTER 2. On the other hand. and fxx = − x2 . In particular.

27) This occurs with probability λdt. t) be a continuously differentiable function of x and t.2. t)dt + b(x− . we note that possible jumps come from dπ.29) (2. combining the above arguments gives f (x− + a− dt + b− dπ. but once again I will provide a nice heuristic argument. t + dt) − f (x− + a− dt. to order dt overall this term is replaced by f (x− + a− dt + b− . t) (2. t)fx )dt + (f (x− + b(x− .28) 2. then overall. this term is zero. That is it! Let’s see an example of this. t + dt) − f (x− . I don’t like this term. No jumps occur with probability 1 − λdt. df = (2. we can think of the effect of the a− dt term as overall being of order dt2 . t) − f (x− . however with jumps dx can be large! Note how this plays into our derivation. ”Heuristic Proof”: We start by writing out the differential and substituting in for dx. t + dt) − f (x . t + dt) − f (x− + a− dt. as dt → 0. t) (2. This time when we consider the differential df we have to be careful because xt jumps! Taylor expansions work well as an approximation when dx is small. Therefore. When it jumps. df = = f (x(t + dt). t) and b− = b(x(t−). 2 (2. Then df (x. t + dt).1 Interpretation of Ito’s lemma for Poisson Ito’s lemma for Poisson processes simply says that when the Poisson process doesn’t jump. 15 (2. t)dπ let f (x. t). t + dt) − f (x− + a− dt.23) where a− = a(x(t−). t). t). use ordinary calculus.26) When their is no jump in dπ. ITO’S LEMMA FOR POISSON PROCESSES (⋆) Ito’s Lemma for Poisson Processes: Given a Poisson stochastic differential equation (SDE) dx = a(x− . t) − − (2. t + dt) − f (x− + a− dt. t + dt) − f (x− + a− dt. t) = (ft + a(x− . t))dπ.2. t + dt) + f (x− + a− dt. t) − f (x− . When there is a jump we have dπ = 1 and f (x− + a− dt + b− . Hence. t + dt) + (ft + a− fx )dt + O(dt2 ) f (x− + a− dt + b− dπ.21) The real derivation of this is using Lebesgue-Stieljies calculus. t + dt) − f (x− . t + dt) − f (x− + a− dt.2. t) − f (x− . t + dt) → (f (x− + b− . so I will add and subtract a term that doesn’t contain the jump df = f (x− + a− dt + b− dπ. t))dπ which completes the derivation of Ito’s lemma. Since the a− dt term in the argument is of order dt.22) − f (x(t−) + a dt + b dπ. Now. the move in f is determined completely by the jump. . so I will approximate them using ordinary calculus. t + dt) → f (x− + b− .25) Now let’s analyze the first two terms (2.24) f (x− + a− dt + b− dπ. (2.20) (2. t + dt) Now the final two terms don’t have a jump in them.

t))dπ This version of Ito’s lemma can be derived in a manner similar to Ito’s lemma for Poisson processes. Heuristic derivations follow along the lines of those for Brownian motion and the Poisson process. then we have the following result. t) = (ft + a− fx )dt + (f (x− + Y b− .3. t) − f (x− . t)dt + b(x− . this can be shown with arguments similar to those given above. then we have the following results (⋆) Ito’s for two correlated Brownians Given the stochastic differential equations dx1 dx2 = = a1 dt + b1 dz1 a2 dt + b2 dz2 (2.35) 2.3 More versions of Ito’s Lemma In this section I will present other useful versions of Ito’s lemma. t)fx + b(x− .3. (⋆) Ito’s for Brownian and Poisson Given a Poisson stochastic differential equation (SDE) dx = a(x− . By Ito’s lemma for Poisson processes.38) . t)Y dπ Let f (x.34) (2. t)2 fxx )dt + b(x− . t) be a twice continuously differentiable function of x and t. It is worthwhile working your way through a couple of them. Ito’s lemma is modified slightly as follows. 2. Then 1 df (x.1 Ito’s Lemma for Compound Poisson Processes When we are using a compound Poisson process. t)dz + Y dπ let f (x. ITO’S LEMMA Example 2. t)fx dz + (f (x− + Y.33) 2. f (x) satisfies df = = = adt + (ln(bx ) − ln(x ))dπ adt + ln(b)dπ (ft + fx ax)dt + (f (x− + (b − 1)x− ) − f (x− ))dπ − − (2.2 Ito’s Lemma for Brownian and Compound Poisson Processes If we combine Brownian motion and compound Poisson processes. t))dπ 2 Again.3. t)dt + b(x− . t) be a continuously differentiable function of x and t.3 Ito’s Lemma for vector processes If we have multiple Brownian motions.16 CHAPTER 2.2.31) (2.1 Let dx = axdt + (b − 1)xdπ and consider f (x) = ln(x). (⋆) Ito’s Lemma for Compound Poisson Processes: Given an SDE dx = a(x− . and through some of the problems at the end.37) (2. t) − f (x− . 2. t) = (ft + a(x− . (2. (2.30) (2.32) 1 where we have used that ft = 0 and fx = x . Then df (x.36) (2.

. it is obvious the area of d(uv) is equal to the sum of the three colored rectangles in the figure. x2 . fxn ] and fxx fx1 x1  . which enters because we are forced 2 to keep the dz term which is of order dt. t) ∈ Rn .4 Ito’s lemma. t) be twice continuously differentiable function of x and t. t) = 1 1 ft + a1 fx1 + a2 fx2 + b2 fx1 x1 + b2 fx2 x2 + ρb1 b2 fx1 x2 1 2 2 2 dt + b1 fx1 dz1 + b2 fx2 dz2 (2.42) 2 where fx = [fx1 . This is a change in the product uv. Without this term. fx2 . x2 . roughly speaking. . . ITO’S LEMMA. The example I will use is the product rule.4. the product rule. x2 .45) Hence. The rectangle in Figure 2.40) (2.39) Using vector notation we can generalize the above result (⋆) Ito’s for vectors Given a vector stochastic differential equation dx = adt + Bdz (2. Now. = . THE PRODUCT RULE. that is d(uv) = (u + du)(v + dv) − uv (2. Ito’s lemma would follow from the intuition of ordinary calculus. fxn xn 2.2. .. AND A RECTANGLE 17 with a1 = a1 (x1 . ···  fx1 xn  . Consider the quantity d(uv). a = a(x. Let me give a little argument (which appears in Rogers and Williams [12]) to try to convince you that Ito’s lemma is actually more intuitive than ordinary calculus. it is natural to expect to see a term related to dudv! In fact. t). it is more mysterious that in ordinary calculus we are able to ignore this term. In ordinary calculus. the terms du and dv are of order dt and hence dudv is a higher order term. That is d(uv) = udv + vdu + dudv. b1 = b1 (x1 .44) We can think of this as the area of a rectangle with sides of length u + du and v + dv minus the area of a rectangle with sides of u and v. b2 = b2 (x1 .43) In fact.e. . (2. x2 . x2 . x2 . we have the familiar formula d(uv) = udv + vdu.. fxn x1  ··· . t) where z1 and z2 are two correlated Brownian motions with instantaneous correlation coefficient ρ (i. . that is because in ordinary calculus. a2 = a2 (x1 . and a rectangle 1 In Ito’s lemma for Brownian motion. Let f (x1 . t). t).1 shows a picture of this.. this is the beginnings of the integration by parts formula. . B = B(x. Let’s try to ”derive” this formula by a simple ”rectangle” argument. E[dz1 dz2 ] = ρdt). Then 1 df = ft + fx a + T r(fxx BΣB T ) dt + fx Bdz (2. Let f (x. (2.. t) be twice continuously differentiable function of x1 .41) where x ∈ Rn . Here it is. Of course. x2 and t. t) ∈ Rn×m and z ∈ Rm a vector Brownian motion with instantaneous covariance matrix E[dzdz T ] = Σdt. the mysterious term is 2 b2 fxx dt. Then df (x1 .

However. since the standard deviation of dz is of order dt.50) where in the last step we have placed higher order terms in o(t) and replaced dz 2 by dt.18 CHAPTER 2. Thus Ito’s lemma for Poisson processes is simply a combination of the ordinary chain rule plus noting that when the Poisson process jumps. we are not a far cry from Ito’s lemma for C 2 functions. This gives us a formula for d(z 2 ).5 Summary Ito’s lemma is the most important result in stochastic calculus for derivative pricing. now you should have an easy time remembering Ito’s product rule d(uv) = udv + vdu + dudv. Then our rectangle formula (product rule) says that d(z 2 ) = d(z · z) = zdz + zdz + dz 2 . This gives an extra term in Ito’s lemma compared to the ordinary chain rule of calculus.47) which is Ito’s lemma for f (z) = z 2 . This is Ito’s lemma for f (z) = z 3 . second order terms in dz are of order dt and cannot be ignored.3. most of the time no jumps are occurring and ordinary calculus is fine. Continuing on in this manner. For Poisson processes. it causes a corresponding jump in any function of the Poisson process. 2. Now we can proceed and choose u = z and v = z 2 . Roughly speaking. for Brownian motion. as they can be approximated by limits of polynomials. any function of it has a corresponding jump. Let us take u = v = z(t). Hence. Furthermore.46) Note that the formula above is exact! Now. From our rectangle and the formula for d(z 2 ) we have d(z 3 ) = d(z · z 2 ) = = = zd(z 2 ) + z 2 dz + dzd(z 2 ) z(2zdz + dt) + z 2 dz + dz(2zdz + dt) 3z 2 dz + 3zdt + o(t) (2.1.1: Ito’s Rectangle Let us see how far we can get from this simple rectangle. when a jump occurs.48) (2. You should be √ familiar with both. There are different versions for Brownian motion and for Poisson processes. you see that Ito’s lemma is actually quite natural if you just remember the rectangle. we have d(z 2 ) = 2zdz + dt (2. we can easily derive Ito’s lemma for any polynomial of any order in z(t)! At that point. (2.49) (2. recalling that dz 2 should be replaced by dt as in the argument of Section 2. ITO’S LEMMA Figure 2. .

Use Ito’s lemma to derive df for a generic twice continuously differentiable f (x. the growth rate of E[xt ] is positive. E(dz1 dz2 ) = ρdt) (a) Use Ito’s lemma to find d(xy). Problem 2. Let f (x. µ ∈ Rn .53) where E[dz1 dz2 ] = ρdt.55) (2. t) = t2 x. t)dz + Y dπ (2.6. y. What is df ? (Hint: Use the same Taylor series argument used in class.51) Problem 2. (i. (b) Use Ito’s lemma to find d(x/y).) Problem 2. Let f (x. (i.56) (2.e.58) Assume that a > 0.6.6. (c) Given dx dy = = (x + y)dt + xdz1 ydt + xdz2 (2. K ∈ Rn×m and z ∈ Rm where z is a vector Brownian motion of m uncorrelated one-dimensional Brownian motions.6 (Counter-intuition) Let dx = axdt + bxdz (2. use Ito’s lemma to derive df for f (x.54) where z1 and z2 are correlated Brownian motions with correlation coefficient ρ.e. Intuitively. Is it possible for E[1/xt ] to also have a positive growth rate? Give conditions on a and b for when this is possible. Problem 2. t) = x2 + t. t) be a twice continuously differentiable function of x and t. Find a stochastic differential equation for df . PROBLEMS 19 2. . use Ito’s lemma to derive df where f (x.2. That is. but this time you can use E[dzdz T ] = Idt where I ∈ Rm×m is the identity matrix. what is Ito’s lemma in this case).6.5 Compute 0 T zt dzt where zt is Brownian motion.6.) Problem 2. t) : Rn ×R → R be a twice continuously differentiable function of x and t. (Hint: consider Ito’s lemma for z 2 . t).6.3 Let dx = adt + bdz1 and dy = f dt + gdz2 (2.1 Consider the Stochastic Differential Equation: where z is Brownian motion and π is a generalized Poisson process with intensity λ and random jumps of size Y . Problem 2. t)dt + b(x. Now consider 1/xt . √ (b) Given dx = −xdt + dπ α .4 Ito’s Lemma Practice √ (a) Given dx = xdt + xdz.6.6 Problems dx = a(x. provide an explanation for this.2 Multidimensional Ito Formula for Brownian Motion: Consider the following vector Ito process: dx = µdt + Kdz (2.57) (2.52) where x ∈ Rn .

) Let dx = adt + bdz (2. 2 Recall our heuristic derivation based on a Taylor expansion: 1 df = ft dt + fx dx + fxx (dx)2 + . (2.. t) satisfies 1 df = (ft + afx + b2 fxx )dt + bfx dz. (dz)2 terms separately.7 Intuition behind Ito’s lemma for Brownian motion. 2 or 1 df = ft dt + fx (adt + bdz) + fxx (a2 (dt)2 + b2 (dz)2 + 2abdtdz) + .61) (2.. 2 (2. compute the standard deviation of the dz.60).6. σ 2 ) is 3σ 4 .) (c) Use this analysis to argue for the plausibility of Ito’s lemma.6. Problem 2. That is.42)..20 CHAPTER 2. Which term has standard deviation of lowest order in dt? (Hint: The fourth moment of a N (0.. (b) Compute the standard deviation of the terms that contain randomness in the above expansion. .60) (2.39) follows from (2. (This intuitive look at Ito’s lemma was communicated to me by Muruhan Rathinam. dtdz.59) then from Ito’s lemma f (x. ITO’S LEMMA Problem 2.62) (a) Compute the mean of df to lowest order in dt using the terms of the Taylor expansion shown above.8 Show that (2.

Let x(t) be the price of a stock. A closed form solution to geometric Brownian motion can be found as follows.3) in log-coordinates x(t) is a Gaussian process with drift a − 1 b2 and volatility b. (3.Chapter 3 Standard Stochastic Differential Equations with Solutions In this chapter we review some stochastic differential equations that have closed form solutions.5) r= x(t) x 21 .2) d ln(x) = (a − b2 )dt + bdz. integrating gives 1 ln(xt ) − ln(x0 ) = (a − b2 )t + bzt 2 which implies that x(t) = e(a− 2 b 1 2 (3. In these solutions. These are also some of the stochastic differential equation models used for modeling asset prices and other relevant financial variables. By Ito’s lemma with f (x) = ln(x) we have 1 (3. That is. these are stochastic differential equations that everyone should know! 3.1. Most importantly.1) Geometric Brownian motion is the following stochastic differential equation where a and b are constants.4) Note that geometric Brownian motion is a log-normal process. note the important role that Ito’s lemma plays. not many stochastic differential equations have closed form solutions. (3. Then over the time period dt. 3.3) )t+bzt x(0). Thus.1 Stock Price Interpretation Geometric Brownian motion is the standard model for continuous asset price movements. (3. 2 Since a and b are constants. Figure 3. It comes from the following. from (3.1 shows a typical sample path of geometric 2 Brownian motion. the return r on the stock x(t) is given by dx x(t + dt) − x(t) = .1 Geometric Brownian Motion dx = axdt + bxdz.

V ar(r) = b2 dt. this process is a Poisson process plus drift in log-coordinates.9) Integrating leads to ln(x(t)) − ln(x(0)) = at + ln(b)π(t) or x(t) = eat+ln(b)π(t) x(0) = eat bπ(t) x(0).10) .7) (3.1: Typical Sample path of geometric Brownian motion. Hence.8) The reason for the term b − 1 is as follows. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS Figure 3. If the current value is x(t) and a jump occurs. this is a very natural model of asset prices. a jump leads to the transition x(t) → bx(t). the instantaneous return r over the next dt is Gaussian with E[r] = adt.22 CHAPTER 3. Note that if we didn’t use this convention. (3. but being driven by a Poisson process.11) (3. (3. we will jump to x(t) + (b − 1)x(t) = bx(t). by writing (b − 1) we think of b as indicating the multiple of the current state that we will jump to if a jump occurs. Again. (3. dx = ax− dt + (b − 1)x− dπ. By Ito’s lemma with f (x) = ln(x) d ln(x) = adt + ln(b)dπ. That is. then we will jump by an amount (b − 1)x(t). Thus.2 Geometric Poisson Motion Geometric Poisson motion is the equivalent of geometric Brownian motion. Geometric Brownian motion models this instantaneous return as dx = adt + bdz x where a and b are constants. Thus. Thus. Thus. (3. there exists a closed form solution that is obtained by changing to log coordinates. it would be a bit messier.6) 3.

The intuition behind our route to the solution comes from the use of integrating factors in basic ODEs. which is π(t) x(t) = e But since Y is lognormal. This results in a process that involves jumps and a diffusion term. Once again. It is modeled as dx = ax− dt + (Y − 1)x− dπ (3. This results in a conditional log-normal process that is different from geometric Brownian motion. π(t) i=1 Zi x(0) 3. π(t) i=1 (3. 3. conditional on π(t). Again.19) (3. more extreme price movements) than the log-normal distribution.18) . dx = ax− dt + bx− dz + (Y − 1)x− dπ (3. using Ito’s lemma with f (x) = ln(x) gives the solution.1 A conditional lognormal version of geometric Poisson Motion The following stochastic differential equation uses a compound Poisson process with a log normal jump size. a change to log coordinates facilitates finding a closed form solution. Hence we have (3. is a lognormal process.3 A jump-diffusion model The following stochastic differential equation uses a generalized Poisson process with a log normal jump size and a Brownian motion. In this way. it can be used to create implied volatility smiles and smirks. conditioned on π(t).14) x(t) = eat+ which.3. we can write it as x(t) = eat πt i=1 i=1 Yi = e Yi  x(0).16) Yi = e )t+bz(t)+ Zi where Zi is normal. Using Ito’s lemma with f (x) = ln(x) gives   π(t) But since Y is lognormal.3. follows the lognormal distribution.17) which.e. A JUMP-DIFFUSION MODEL 23 3. It is known as a jump-diffusion model.12) where Y = eZ is a lognormal random variable. This model is nice because it can produce distributions that have heavier tails (i. To solve this.13) Zi where Zi is normal.2. π(t) i=1 (3.15) where Y is a lognormal random variable. dx = (a + bx)dt + (c + f x)dz. Hence we have Zi x(t) = e(a− 2 b π(t) i=1 x(0) (3.4 A more general SDE The following SDE contains a slightly more general description of an SDE driven only by Brownian motion. we can write it as (a− 1 b2 )t+bz(t) 2 i=1 π(t) i=1 1 2 Yi x(0). (3. first write the SDE as follows: dx − bxdt − f xdz = adt + cdz.

x(t) is drawn toward a at a rate of b.27) Thus. and b is the mean reversion rate. observe that x(t) is a Gaussian process as well. (3.26) where a is the level that x(t) reverts to. (3. This is undesirable because prices and quantities such as interest rates should not be negative. The Brownian driven term cdz just adds noise. A standard model for this is a Gaussian model called the Ornstein-Uhlenbeck process [14]. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS In standard ordinary differential equations. (3. it has a closed form solution.2. its long term mean level). The solution is given by t x(t) = e−bt x(0) + 0 e−b(t−s) (abds + cdz(s)). dx − bxdt − f xdz = 0.1 The Ornstein-Uhlenbeck Process and Mean Reversion A very useful model is one in which a price or financial variable is mean reverting. One disadvantage of this process is that values of x(t) can become negative because the Gaussian distribution always has some probability of being negative.18). we would try to make the left hand side an exact differential by using an integrating factor.24 CHAPTER 3.21) )t−f z(t) . The solution to this is x(t) = x(0)e(b− 2 f Hence. Vasicek used a process of this form to model the short rate process in term structure modeling [15]. the process is pulled toward some value (in this case. That is. That is.23) t )t−f z(t)) x(t) − x(0) = e(−(b− 2 f 0 1 2 )s−f z(s)) ((a − f c)ds + cdz(s)) (3. . Thus.20) )t+f z(t) . (3. dx = −b(x − a)dt + cdz (3.25) 3. The integrating factor is usually related to the solution to the differential equation if the right hand side of (3. Mean reverting processes of this specific form are sometimes also called a Vasicek model. A sample path of a mean reverting process is depicted in Figure 3.24) and rearrangement gives the final form x(t) = e((b− 2 f 1 2 t )t+f z(t)) x(0) + 0 e((b− 2 f 1 2 )(t−s)+f (z(t)−z(s)) ((a − f c)ds + cdz(s)). we will try an integrating factor of the form e−(b− 2 f Therefore. (3.19) is set to zero.22) )t−f z(t) x) = e−(b− 2 f 1 2 )t−f z(t) 1 1 −(b − f 2 )xdt − f xdz + f 2 xdt 2 2 +(a + bx)dt + (c + f x)dz − f (c + f x) dt = Integrating both sides leads to e(−(b− 2 f 1 2 e−(b− 2 f 1 2 )t−f z(t) ((a − f c)dt + cdz) .4. Since a mean reverting process is of the form of (3. let us compute d(e−(b− 2 f 1 2 1 2 1 2 (3.

31) 2 2 where the Brownian motions z1 .3.2: Simulation of Mean-Reverting Dynamics.32) n By Ito’s lemma.6 2.2 2 1. This makes the noise dependent on the size of x. .35) β2 4 β2 4 n dt + i=1 n (βyi dzi ) (yi dzi ) i=1 = −αx(t) + n dt + β . c = 0.4 x 2. . COX-INGERSOLL-ROSS PROCESS Simulation of Mean−Reversion Dynamics 3 25 2. .5 Cox-Ingersoll-Ross Process Another version of a mean reverting process is the Cox-Ingersoll-Ross (CIR) process [4]. . b = 5.30) 1 1 dyn = − αyn dt + βdzn (3.34) (3. . x(0) = 3. (3.5. . . Note that it is very similar to the √ Ornstein-Uhlenbeck process. Furthermore.29) 2 2 . Now. + yn (t) (3.28) dx = −b(x − a)dt + c xdz and used often in short rate models or stochastic volatility type models. except that the driving Brownin motion is multiplied by x. with correct parameter values. a = 2. . This process is related to the Ornstein-Uhlenbeck process as follows. It is given by √ (3. zn are uncorrelated. x(t) follows dx = = i=1 1 1 2yi (t) − αyi dt + βdzi 2 2 i=1 n 2 −αyi + n + i=1 β2 4 dt (3. this process will always be positive.8 2.8 1.5.6 0 1 2 t 3 4 5 Figure 3. 3.33) (3. Consider n Ornstein Uhlenbeck Processes 1 1 dy1 = − αy1 dt + βdz1 (3. consider the process 2 2 x(t) = y1 (t) + .

dt). note that if we interpret each Brownian increment as being normally distributed with mean zero and variance dt.6 Summary In this chapter we have explored some of the standard stochastic differential equation models used in finance. 3. Hence. dzi ∼ N (0.40) to convert (3.37) is normally distributed. overall.39) where we used that the dzi ’s are independent and equation (3. For it to be the increment of Brownian motion. 4 b = α. It is important to have a feel for these processes what their parameters correspond to. You can think of these models as building more and more complicated models from our basic building blocks of Brownian motion and the Poisson process. c=β (3. then (3.37) is just the sum of Gaussians.41) Now. Thus.28) and (3. it turns out that x(t) i=1 yi x(t) yi x(t) dzi . we have the solution as the sum of Ornstein-Uhlenbeck processes. To compute the mean we have n E i=1 yi x(t) n dzi = i=1 yi x(t) E[dzi ] =0 (3. c2 For n corresponding to an integer. This gives ab = nβ 2 .36) n i=1 dzi (3. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS Now. we should always make sure that our parameter choices correspond to selecting n ≥ 2.32). (3.26 CHAPTER 3.38) and the variance is computed as n V ar i=1 yi x(t) n dzi = i=1 2 yi V ar(dzi ) x(t) n = i=1 2 yi dt x(t) = dt x(t) n 2 yi = dt i=1 (3. we are guaranteed to have a positive process (otherwise the process can and will reach zero at times!). .41). But. i. it turns out that for n ≥ 2.e. Note that most of them correspond to some transformation of simple Gaussian processes such as the Ornstein-Uhlenbeck process or the Poisson process. heuristically. Thus. (3. we only need to show that the mean is zero and the variance is dt.37) is actually a Brownian motion! How can we see this? Well. This is easily done since we can match coefficients in (3.35) to dx = −αx(t) + n dt + β x(t)dz (3. the process x(t) will be Chi-Squared distributed. A sample path of a CIR process is depicted in Figure 3.3. we get that n = 4ab . we perform a little trick by writing the last term as n β Now. it is a well known property that the sum of Gaussians is Gaussian.42) From these relationships. Thus we can actually use the replacement n dz = i=1 yi x(t) β2 4 dzi (3.

7. t) = e−(b− 2 f dz = dz and use the multidimensional Ito’s lemma. a = 2.5 x 2 1. x(0) = 3. This model is log-normal due to the fact that x is normal. z.43) Using Ito’s lemma. derive a stochastic differential equation for y = ex in terms of only y.2 Consider the process dx = −b(x − a)dt + cdz (3.3 Verify equation (3. PROBLEMS Simulation of CIR Dynamics 3 27 2. but has a mean reverting property in log coordinates.7 Problems Problem 3. (c) What does your answer in (b) look like if Y is log-normally distributed.5 0 1 2 t 3 4 5 Figure 3. c = 0. Problem 3.7. 3. b = 5.7.23).7. Problem 3.3. (Hint: Let f (x.1 Solve the following stochastic differential equations: (a) dx = µdt + σxdz (b) dx = µxdt + σxdz + x(Y − 1)dπ where π is a Poisson process with intensity λ and Y is a random variable.) 1 2 )t−f z x where z has the trivial sde .3: Simulation of a sample path of a CIR process.5.

28 CHAPTER 3. STANDARD STOCHASTIC DIFFERENTIAL EQUATIONS WITH SOLUTIONS .

This is a one factor model. we adopt that paradigm here. We will also consider multifactor models of the form n r =α+ i=1 βi fi (4.Chapter 4 The Factor Approach to Arbitrage Pricing 4. But first we must understand the underlying principle.1 shows the cash flow diagram corresponding to this where the time increment it denoted as dt... Figure 4.1 The Factor Approach to Arbitrage Pricing In this chapter we present absence of arbitrage conditions when returns are described by linear factor models.1 Returns Above I said we would model returns as factor models. 29 . To back up this claim we will derive pdes in a great number of situations. However. factor models should arise from price changes as well. . a simple absence of arbitrage equation results in perhaps the simplest way to obtain the vast majority of Black-Scholes type pdes that appear in derivative pricing. However. In doing so. Let’s begin. 4. Given a period of time ∆t. 4.2.1) where a and b are constants and f is a random variable called a factor.2) where each fi . a return is assumed to be of the form r = α + βf (4. we do so in light of the application to derivative pricing..2 Returns and Factors Models Most of the modeling in asset pricing theory is done using linear factor models. which is in fact quite simple. That is. i = 1.3) where P (t) is the amount invested at time t and P (t + ∆t) is the amount received at time t + ∆t. n is a random factor. returns are also related to price changes.. we rely heavily on Ross’ Arbitrage Pricing Theory [13]. Hence.. Hence. the return on an asset is defined as r= P (t + ∆t) − P (t) P (t) (4. We will find in the following chapters that when coupled with Ito’s lemma.

and I can use it to determine a model of returns: r= dx(t) a(x(t).4) dS = µSdt + σSdz. t) b(x(t). if I am given a stochastic differential equation dx(t) = a(x(t).6) then it is describing price changes over time period dt. I like to go even a little further and interpret dt as a special factor which is non-random.7) This also looks like a factor model with the factor being dz.t) (and arguments are being suppressed). not just Brownian motion. t)dt + b(x(t). for the sections that follow. a stock price could be (4. and f = dz then it is a standard linear factor model. t) = dt + dz x(t) x(t) x(t) (4. . it is given by: r= S(t + dt) − S(t) dS(t) = = µdt + σdz. not just an instantaneous change in time. This is a model of a price change over time dt. including x(t) (or t− and x(t−) if appropriate). I like to write it in the form: r = αdt + βdz (4. and dt can be any time increment. For instance. t)dz (4. In what follows. you may think of the factor dz as being any random variable. Therefore. Another note is that α and β don’t seem to be constant! However. Therefore.2.30 CHAPTER 4. In fact.2 Stochastic differential equations and factor models In finance. Hence. x(t) is known and α and β are then known constants over time t to t + dt. I will use notation that is indicative of SDEs in that factors will be denoted by dz and I will include a special factor dt when I describe returns.8) where α = a(x(t). if we associate α = µdt.t) and β = b(x(t). However. In general. S(t) S(t) (4. β = σ. but I will use this convention throughout. In the above formula. This is slightly different from x(t) x(t) the standard factor model in that I explicitly write out dt in the first term. This is purely for convenience. conditioned upon information at time t. I should be able to use it to compute the return of an asset over time dt.1: Cash Flow Diagram 4. In fact. we like to model asset prices as stochastic differential equations. SDEs lead to instantaneous factor models that apply over time increments of dt. THE FACTOR APPROACH TO ARBITRAGE PRICING Figure 4. we should view a factor model from an SDE as being valid only over dt and conditioned upon information at time t.5) This is also an example of a factor model.

9) where r ∈ Rn . If this stock pays a dividend. only a share. I must have no return as well. I mean an asset that you can actually buy. (4. the total change in our portfolio is given by: n profit/loss = i=1 xi ri = xT r. If it had a negative return. you can purchase a share of stock. then when you purchase the share of stock. Let’s list the returns of tradable assets that are driven by the factor dz r = αdt + βdz (4. then it better have no return! If it had a positive return. to have no arbitrage. That is. since I would be guaranteed to make money (no risk). If xT β = 0 then the return on this portfolio is deterministic and given by xT αdt.9) indicate the change in value of each tradable asset. The factors are contained in the vector dz ∈ Rm . That is xT 1 x β T = = 0 No cost 0 No risk (4. THE FACTOR APPROACH TO ARBITRAGE USING RETURNS 31 4.11) We can analyze this return in a little more detail by writing out what each ri is xT r = xT (αdt + βdz) = (xT α)dt + (xT β)dz. this would be an arbitrage.1 Arbitrage Let us consider a simple portfolio. the returns in (4. I have stacked up all the returns in a vector. We can now see that this return will be riskless as long as xT β = 0 (4. then the portfolio −x would be an arbitrage. the total cost of our portfolio is n cost = i=1 xi = xT 1 (4. α ∈ Rn are vectors and β ∈ Rn×m is a matrix. Now consider a portfolio of these assets. For instance. This leads us to a key condition which I state as the following implication (⋆) A (not very useful) Necessary Absence of Arbitrage Condition xT 1 = 0 No cost xT β = 0 No risk ⇒ xT α = 0 No return (4. if something costs nothing and has no risk. and I didn’t use any money to do it (no cost).3. So. you have purchased the dividend stream as well.12) since that is the coefficient of the dz term which is providing the randomness. 4. By a tradable asset. Note that you cannot just purchase the ”price” of the stock. Hence.4.14) (4.3. We will represent the portfolio by a vector x ∈ Rn which denotes the dollar amount invested in each tradable asset.16) .13) (4.3 The Factor Approach to Arbitrage using Returns We consider the returns of tradable assets. Over the time period dt.10) where 1 is a vector of ones. I will choose this portfolio so that it costs nothing and has no risk.15) But. Hence. let’s consider the returns of tradable assets. Therefore. and hence you are stuck with everything that comes along with purchasing a share (such as dividends).

17). It’s importance cannot be overstated. Let M be a set of vectors.19) On the other hand. (⋆) Null and Range Space Relationship: N (A)⊥ = R(AT ). (4.24) T (4. then M ⊥ is a set of all vectors z such that z is orthogonal to all vectors in M .17) into a very useful condition. However.21) In order to derive a useful condition from (4.17) can be written as Ax = 0 ⇒ αT x = 0 where A = .18) Now. That is exactly saying that N (A)⊥ = R(AT ). 2. the set of all vectors y such that there exists an x with y = Ax is known as the range space of the matrix A. (4. (4. we recall the notion of the perpendicular set of a given set of vectors. That is N (A) = {x|Ax = 0} . the above condition for absence of arbitrage is not terribly useful. ∀x ∈ M (4. we can convert (4.17) As the name indicates. Hence it receives two stars!! (⋆⋆ Return APT) A Useful Necessary Absence of Arbitrage Condition . x ∈ N (A) ⇒ Ax = 0 ⇒ y T Ax = 0 for all y. THE FACTOR APPROACH TO ARBITRAGE PRICING which can be written in matrix form as 1T βT x = 0 ⇒ αT x = 0. That is M ⊥ = z | z T x = 0.32 CHAPTER 4. we need to first recall some linear algebra relationships. Proof: The proof of this is rather simple.3. That is R(A) = {y | ∃x such that Ax = y } . Then y T Ax = (AT y)T x = 0 which means that A y is orthogonal to the null space of A for all y. the set of all vectors x such that Ax = 0 is known as the null space of the matrix N (A). (4.20) Finally.23) 4.3. (4. we will use the following relationship between the null and range space of a matrix.22) (4. 4. In fact. an equivalent condition is extremely useful and will provide the foundation for our derivations of partial differential equations. the condition which is stated next is astonishingly useful! But to derive it.3 A Useful Absence of Arbitrage Condition Using the null and range space relationship.2 Null and Range Space Relationship 1T βT Note that the condition (4.

On the left side is the expected return (µ).4.27) where N (·) is the null space.29) Let’s look at this equation. we might guess that λ0 = r0 . . For this reason. and on the right side is the volatility (σ). If σ is zero. But. Therefore. A better way to think of σ is not as volatility. Another way to put this is that α∈ N 1T βT ⊥ λ0 λ (4. where r0 denotes the risk free rate of interest. we also have this pesky λ0 to deal with. Proof: Note that the condition in (4. Many of you will hopefully recognize this as nothing more than the simple version of Ross’ 1976 arbitrage pricing theory [13]. Hence. If it is large. Its derivation is given below. In fact. σ = 0). then µ = λ0 . this means that α∈R 1T βT T (4. then you have purchased a lot of that risk. Market Price of Risk The APT equation for a single factor model r = µdt + σdz is ˆ µ = [ 1 σ ]λ = λ0 + σλ1 . then we should be earning the risk free rate. Hence. there exists a vector λ ∈ Rm+1 such that [ 1 β ]λ = α. let’s justify this through a slightly different argument that will also get us a nice interpretation for λ0 . THE FACTOR APPROACH TO ARBITRAGE USING RETURNS 33 A necessary and sufficient condition for the implication (4. this equation relates volatility to expected return. using the null and range space relationship.28) ˆ ˆ Thus. The Market Price of Time But. (4. This is in fact correct. It is not tied to any risk. if we don’t have any risk. but as the amount of the risk factor dz that you have. λ1 tells you how much your expected return is increased (assuming λ1 is positive) for each unit of the risk dz that you take on. then you are not exposed to the risk dz at all. λ1 is the market price of the risk factor dz.3. This is a nice interpretation for λ1 .3. if we don’t take on any risk (i.4 Interpretations Let’s try to get a bit of intuition into the mystical λ’s. In this case.e.26) (4. Intuitively. But.16) to be true is for there to exist a vector ˆ λ ∈ Rm+1 such that ˆ 1 β λ = λ0 + βλ = α (4.25) where ˆ λ= with λ0 ∈ R and λ ∈ Rm . 2 4.17) indicates that if a portfolio x is in the null space of the matrix 1T βT then it also must be orthogonal to α. λ1 is called the ”market price of risk”.

If the λ’s are the market prices of factors.2. the profit/loss on the portfolio is given by: Therefore. Therefore. and dz ∈ Rm .4.33) In this case.32) 4. every factor has a market price.3. There are contracts that involve no up-front cost or price. we let r ∈ Rn be the returns of assets and specified the dollar amount invested in each asset by a vector x ∈ Rn . 4. they don’t have a well defined return. The cash flow from changes in value over the period will satisfy the factor model dV = Adt + Bdz where A ∈ Rn .1 Price Changes and Arbitrage Let’s return to our arbitrage portfolio and reformulate it in terms of price changes. This time we will specify a vector of prices per unit of tradables P ∈ Rn . B ∈ Rn×m .4 The Factor Approach using Price Changes I just mentioned that there can be some problems in dealing with returns. In a market with no arbitrage. They relate the different factors dt. A futures contract is an example of this. since the risk free rate is the amount we are rewarded for taking on time and nothing else. I don’t like special cases. dz. Hence. Since it must satisfy our return relationship. Now all the λ’s should make sense. Intuitively.31) which tells us that λ0 = r0 .34 CHAPTER 4. we have: r0 = λ0 + 0(λ1 ) = λ0 (4. an arbitrage portfolio is one that has: . since by definition a return involves dividing by the price. THE FACTOR APPROACH TO ARBITRAGE PRICING Let us consider a risk free asset. which can be zero. it will be okay to have an asset with a zero price. in this section we will reformulate the factor approach to arbitrage pricing by working with prices rather than returns. cash flows resulting from the changes in value of the tradables per unit dV ∈ Rn . (4. since the mark-to-market mechanism resets the value of a contract to zero every day. this makes perfect sense.2 Profit/Loss and Arbitrage y T (dV) = y T (Adt + Bdz) = (y T A)dt + (y T B)dz (4. then we may interpret λ0 as the reward for the time factor dt or the ”market price of time”. so below we will reformulate absence of arbitrage conditions but in terms of price changes rather than returns. It is very useful to have this intuition. This eliminates the need for special cases.4. and shares or units of each asset purchased y ∈ Rn . In this case. 4. In our original argument.30) where r0 is a constant risk free rate of interest. Don’t forget it. right? This is the basic interpretation of the concept of ”market price of risk”. a futures contract must be dealt with as a special case. to how much we are rewarded for taking on those factors. Its factor model is given by: dB0 = r0 dt B0 (4. Quite simple. and multiplying them by their market price and adding them up. The simple cash flow diagram is given in figure 4. Hence. etc.5 A Problem with Returns Using returns to model assets has a disadvantage. in the above framework. Your return is just given by looking at how much of each factor you have taken on. 4.

They are market prices of risk. The λ’s in both cases are the same.4. Furthermore.37) B λ = Pλ0 + Bλ = A (4. What is the relationship between the return approach and the price change approach. • No Risk: y T B = 0. but has a profit • Profit: y T A = 0. and have the same interpretation.2: Cash Flow Diagram with Prices P and Value Changes dV • No Cost: y T P = 0. Well. it describes profit/loss in terms of the cash flow. (⋆) A (not very useful) Necessary Absence of Arbitrage Condition y T P = 0 No cost y T B = 0 No risk which can be written in matrix form as PT BT y = 0 ⇒ AT y = 0. not returns. in the price approach rather than in terms of returns. THE FACTOR APPROACH USING PRICE CHANGES 35 Figure 4.4. so we would like the following implication to hold. but it is easier to understand some pricing situations. λ0 λ (4.35) ⇒ y T A = 0 No return (4. (4.34) Once again. Of course. of course they are highly related. not dollar amount. such as futures contracts. These are really superficial differences. we want to eliminate arbitrages.36) . The main difference is that the price approach uses shares or units of the asset to describe the portfolio. we can convert this to a dual condition that is useful: (⋆⋆Price APT) A Useful Necessary Absence of Arbitrage Condition ˆ A necessary condition for no arbitrage is for there to exist a vector λ ∈ Rm+1 such that P where ˆ λ= with λ0 ∈ R and λ ∈ Rm .

Prices We can derive the same results using prices. the absence of arbitrage ˆ equation says that [ P B ]λ = A or B S Solving this equation for λ0 and λ1 gives λ0 λ1 as expected.1 Stocks Assume that a stock follows a geometric Brownian motion (GBM) and there is a bond that earns the risk free rate.38) (4.47) 0 σS λ0 λ1 = r0 B µS (4.39) What do our absence of arbitrage conditions say about these assets? Returns In terms of returns.42) = = r0 dt µdt + σdz (4. we can write that: dB B dS S ˆ Hence. the APT equation says [ 1 β ]λ = α or 1 0 1 σ Solving this equation for λ0 and λ1 gives λ0 λ1 = = r0 µ−r σ (4. = = r0 µ−r . Let’s start with a stock and a bond. 4. We will see this equation pop up many times.44) λ0 λ1 = r0 µ (4.41) Note that the market price of risk for dz is like an instantaneous Sharpe ratio. (4. r0 .36 CHAPTER 4. Their dynamics are given below: dB dS = = r0 Bdt µSdt + σSdz. In terms of prices and changes in value.45) .5. THE FACTOR APPROACH TO ARBITRAGE PRICING 4.43) (4.5 Two standard examples In this section we will give some little examples to help us gain some intuition into the approach. σ (4.40) (4.46) (4.

Now let’s look at the price based arbitrage equation [ P B ]λ = A or B 0 Solving this equation for λ0 and λ1 gives (4.3: Cash Flow Diagram for Futures Contract Therefore.5. we see that the equations separate. a futures contract can have zero price. and is difficult to understand in the context of returns because its return is not defined (it has zero price!). (4. At the end of the day. SUMMARY 37 4. Note that this price change is not discounted. But before doing so. Hence.51) r0 µ . This means that they always begin the day with a zero price.6 Summary We have derived forms of an aribtrage pricing theory based either on linear factor models of returns or value changes. in this case. we develop a .) equations that arise in derivative pricing theory. time is fixed.6.4. and a futures contract is purely a bet on the outcome of a random factor. The critical difference between futures contracts and forward contracts is that futures contracts are marked to market and settled daily. The bond is purely time. the price change is settled. It is much more naturally considered in terms of prices and value changes. This means that a futures contract is a special case in our setup.52) λ1 = σ Note that a futures contract refers to the price at a fixed time in the future. the change in value of the portfolio is equal to the change in the futures price dV = df ! Figure 4. Hence. but rather the change in the futures price. Hence time is not mixed into it. and the market price of time is r0 . Below is the cash flow diagram for a futures contract. we may consider a market with a bond and a futures contract. Hence. (4. but the cash flow from the change in value will be given by df = µf dt + σf dz. Time is not in the mix. (4. the futures contract is purely a bet on the outcome of the factor. The relevant quantities can be written as prices changes factors B dB = r0 Bdt (4. λ0 = 0 σS λ0 λ1 = r0 B µS .2 Futures contracts One can enter into a futures contract without paying any money.48) Hence. and the market price of risk does not involve the risk free rate r0 . On the other hand.50) 4.49) 0 df = µf dt + σf dz. These simple results will allow us to derive many of the partial differential (or difference/integral/etc.

58) Prove by use of the Farkas alternative that this implication is true if and only if there exists a λ such that b = AT λ. That is.56) subject to 1T x = 0. Problem 4. in following chapters we tackle examples in equity derivatives. One could then solve the optimization problem max γ T x x (4.7.55) If λ∗ is this optimal λ. and beyond. β T x = 0. β T x = 0.57) Show that this optimization problem is equivalent to the optimization problem in (4. as follows. However. then we can define γ = α − [1 β]λ∗ . λ (4.38 CHAPTER 4. Then.59) T T (4. (4. β T x = 0.2 (More Linear Algebra and Dualities) The Farkas Alternative [7] of linear algebra says the following (i) Ax = b has a solution x ≥ 0 or (exclusive) (ii) y A ≥ 0.60) . What you should take away is that simple arbitrage ideas that we derived in this chapter are the underpinnings of derivative pricing theory.) Problem 4. Let’s explore how this would affect the absense of arbitrage ideas.53) subject to 1T x = 0. interest rate derivatives.7. y b < 0 has a solution y. 4.54) where the constraint x 1 limits the total dollar amount of long and short positions to equal $1.7 Problems Problem 4.1 (How to construct an arbitrage) Assume that there does not exist a λ such that α = [1 β]λ.3 (Early Exercise and American Options) American options allow the holder of the option to exercise at any time prior to expiration. (4. THE FACTOR APPROACH TO ARBITRAGE PRICING derivative pricing framework based upon our APT factor based approach. (Hint: Note that the implication is true if and only if there is no solution to Ax = 0 and bT x > 0. Choose λ such that α − [1 β]λ has minimum 2-norm. x 1 = 1. (4. We can use the Farkas Alternative for implications as well. there exists a vector x specifying dollar amounts invested such that αT x > 0 and 1T x = 0. x 1 = 1. in practice an alternative but equivalent approach is often used. One way to select a specific arbitrage would be to solve an optimization problem of the form max αT x x (4.7. Then this means that an arbitrage opportunity exists. That is min α − [1 β]λ 2 .54). Consider the implication: Ax = 0 ⇒ bT x = 0 (4.

62) Problem 4. where the first elements of these vectors α1 and β1 corresponds to the American option. derive that an alternative absence of arbitrage condition is that there exists scalars ξ ≥ 0. is either r1 = αc dt + βc dz or r1 = depending on whether the option is exercised or not.7. using (4.62) is being chosen. Finally. 1T x = 0. both of the following conditions must hold αc E ≤ ≤ λ0 + βc λ1 c.4.) (c) Assume that the vectors e1 . and λ0 and λ1 such that α = λ0 + βλ1 − e1 ξ.64) and Part (a) of this problem.p.4 (Modeling the binomial lattice as a factor model) Consider a stock that can move on a binomial lattice. argue that for the American option.p.64) (d) Finally. As the holder of an American option. 1 − p (4.65) (4.68) uS(k) dS(k) w. you get to decide when to exercise the option. (4.66) (4.61) Explain why the factor model for the return on an American option.67) Show that ∆S(k) = S(k + 1) − S(k) can be written in the form ∆S(k) = A(k) + B(k)∆Z(k) by finding A(k) and B(k).69) . p w. (b) Assume that you are long the American option. where E is the early exercise value and c is the price of the option. where at each step the stock price S(k) can either move up to S(k + 1) = uS(k) or down to S(k + 1) = dS(k) with the probability structure S(k + 1) = Let ∆Z(k) be a standard binary random variable ∆Z(k) = 1 w. (4. Let α and β correspond to factor models for tradable assets. Using the Farkas Alternative from Problem 4.e. 39 (4.7. 1 − p (4. p −1 w. 1.. Argue that a necessary condition for you not to be able to arbitrage is that the following implication is true regardless of whether you are exercising the American option or not. e1 T x = 1.p.p. (4. (I. the implication must hold regardless of which return in (4. β are linearly independent.63) E−c dt cdt (4.7.2. let x be a vector of dollar amounts invested in each asset (with x1 corresponding to the American option). PROBLEMS (a) Assume that the factor model for the option if it is not exercised is r1 = αc dt + βc dz. β T x = 0 ⇒ αT x ≤ 0.

40 CHAPTER 4. THE FACTOR APPROACH TO ARBITRAGE PRICING .

5. in our models. I will also emphasize the relative pricing nature of derivative pricing. we will be interested in the pricing of derivative securities. an interest rate could be an underlying variable. The examples are a call option on a non-dividend paying stock. In general. dπ. the factors will show up as the dz. underlying variables. and tradables. derivative pricing determines an appropriate price relative to other securities that have already been priced in a market. and to provide an almost step by step method for attacking any problem. we will classify all quantities into three (possibly overlapping) categories.2 A Classification of Quantities In this book.2. I will use two derivative pricing examples to illustrate points.1 Introduction This chapter lays the framework for derivative pricing. and used in the modeling process. I like to think of time as a special factor. and dt terms. In our modeling framework. A stock price S(t) could also be an underlying variable. they are the driving Brownian motions (z(t)) and Poisson processes (π(t)).1 Factors Factors are the most basic source of randomness in our models. That is. Thus. the goal is to clarify the structure of the modeling involved in the factor approach. we try to provide the structure behind the factor approach.2. underlying variables are financially relevant quantities that are functions of the factors. However. 5. let’s start by classifying the relevant quantities in a model of any market. They are factors. 5. In general. and an absence of arbitrage zero coupon bond pricing model. In particular. it is best to first understand the general modeling paradigm.2 Underlying Variables Underlying variables are often quantities of interest that are functions of the factors. Furthermore. Before jumping into any of these ideas of derivative pricing. 41 . That is. to understand that pricing theory. As I proceed through this chapter. For example. Thus.Chapter 5 Constructing a Factor Pricing Framework 5.

In this case.42 CHAPTER 5. and represented as a function of the underlying variable. Instead.4 A Derivative is a Tradable In this book we are interested in pricing derivative securities. let’s consider the example of a stock that pays a dividend. t) is tradable. a bond B(r(t). a stock price S(t) can be an underlying variable.2. In other cases. Note that this definition of a derivative does not particularly distinguish it from any other tradable! We typically model all tradables as being a function of some underlying variables (although often a tradable is an underlying variable and hence trivially a function of itself). However. Instead. You will see that the most important distinction is that a derivative is ”what you want to price” and that other tradables are ”already priced” in the market. For example. an interest rate r(t) can be an underlying variable. Example: A stock paying a dividend To make sure we understand what a tradable is. if you started by purchasing 1 share of stock at time 0.2. 5. by time t you would have eqt shares. and let’s assume that it pays a continuous dividend at a rate of q. the tradable is a more complicated function of an underlying variable. the functional relationship between the tradable and an underlying variable is trivial. What is the tradable quantity? You might be tempted to say that the price of the stock S(t) is tradable. Derivative Security: A derivative security is a tradable whose value depends upon (or is a function of) other underlying variables. we say that the derivative security is derivative to the underlying variables. They come together and that is the tradable. What this means is that by reinvesting the dividend back into the stock. And those absence of arbitrage relationships will lead to our pricing formulas. The name derivative comes from the fact that the value of a derivative is ”derived” from some underlying variables. note that you cannot just purchase the ”price of the stock”. The stock has price S(t).3 Tradables Tradables are the quantities that you can actually trade and include in a portfolio. are the quantities that must satisfy the absence of arbitrage relationships from the previous chapter. there is no real distinction between a derivative and any other tradable. In order to have something to keep in mind. Let’s consider an example to clarify the notion of what is tradable. The point is that you can’t decouple the price from the dividend. Figure 5.1: Picture of the Modeling Paradigm It is extremely important to be able to separate quantities that are tradable from those that are not. it is important to begin by defining what we mean by a derivative security. and with this share you not only get the price of the stock but also the dividend. let’s use the following example: . They are modeled as being functions of the underlying variables. you must purchase a share of stock. CONSTRUCTING A FACTOR PRICING FRAMEWORK 5. and also a tradable. and only tradables. Why? Because tradables. but it is not tradable. Some of the time. For example. So. In principle.

5. The first is that we directly model the tradable as a factor model. 5. we begin the modeling process by writing down SDEs (or factor models) for underlying variables and tradables. which is the option to purchase a specified stock.3.3) which is a factor model for the call option c. The call option is a function of the underlying stock price S(t) and time t. it is not always the case that the underlying variable must also be tradable. Then.2 Factor Models via Ito’s Lemma The second method to obtain factor models is via Ito’s lemma. we begin the modeling process by writing down a factor model or SDE. in many case. t). Examples of this include the geometric Brownian motion model of stock price movement. In some cases. etc. However. because its value depends upon the stock price of Coca-Cola.1) Thus.5. in continuous time models.3. at a specified date (the expiration date). we would like SDE models for underlying variables and tradables in particular. (5. In this example. dS = µSdt + σSdz or a model of an interest rate (most likely the instantaneous short rate) as an SDE dr0 = adt + bdz. are functions of underlying variables. the stock price of Coca-Cola is the underlying variable. Hence. 5. A picture of the route to SDEs for tradables is given in Figure 5. Thus. there are derivatives that depend on underlying variables such as temperature or even wind speed which clearly are not tradable. and derivatives in particular.1 Direct Factor Models In many cases.3. derivative securities are quite flexible. in Ito’s lemma we would be able to explicitly compute the partial derivative terms ct . In general. by Ito’s lemma we have 1 dc = (ct + µScS + σ 2 S 2 cSS )dt + σScS dz 2 (5. if we have an SDE model for an underlying then we can use Ito’s lemma to obtain an SDE for the tradable. We write this as c(S(t). say Coca-Cola. what we need are linear factor models for the price changes of tradables. Consider the example of a European call option on a stock following geometric Brownian motion as in (5. Coca-Cola is an underlying variable and also a tradable. In that case. for a specified price (the strike price). The second (and most important) is Ito’s lemma.3 Factor Models for Underlying Variables and Tradables To use the APT equations from the previous chapter. there are two ways that we arrive at factor models for tradables. FACTOR MODELS FOR UNDERLYING VARIABLES AND TRADABLES Example: European Call Option 43 Consider a European call option. and so are the possible underlying variables.2 . In fact.2) (5. we will know explicitly the functional relationship between the tradable or derivative and the underlying variable. cS . In this case. In general. In the previous chapter we saw that we can interpret SDEs as instantaneous factor models. Since tradables.1). the option is a derivative.

5.36). This emphasizes the relative pricing nature of derivative pricing. CONSTRUCTING A FACTOR PRICING FRAMEWORK Figure 5.4) 5.44 CHAPTER 5. You should contrast the marketed tradables with the derivative that we would like to price. What we mean by a marketed tradables is a tradable that is ”already priced” by the market. However. For instance. the tradable table is Prices   B  S  c Changes   B d S  c Factor Model  = This is called a tradable table to emphasize the fact that only tradables need satisfy the absence of arbitrage conditions. we need two things: prices and factor models for value changes. derivative pricing is a method of pricing a new tradable (the derivative) consistently with the existing price of marketed tradables. we call this a tradable table. When we list these in a table. we designate certain tradables as marketed. and a call option on the stock. It supplies all the basic information that we need to extract from the market when applying the Price APT. we can tabulate prices and factor models for value changes for all tradables.5. rather than the Return APT. The previous section indicated how to obtain the factor model for value changes. The derivative is what we ”want to price” using the information given from the marketed assets. That is. a bond. in a market with a stock.5) Bm Am Pm Vm = dz dt + d B A P V . we first separate marketed tradables from the derivative the we would like to price.   r0 B 0  dt +  σS  dz  µS 1 σScS (ct + µScS + 2 σ 2 S 2 cSS )  (5.1 Relative Pricing and Marketed Tradables Once we have set up the tradables table.5 Applying the Price APT The final step to a derivative pricing equation is to apply the Price APT equations. 5. Thus. and put them all in a tradables table.4 Tradables tables We will approach the derivative pricing problem using the Price APT equation (4. We price a derivative security relative to the marketed tradables. we separate the marketed tradables from the derivative. But note that everything in this book can also be done use the Return APT equation. before applying the Price APT equation. Factor Model Changes Prices (5. To see how this works. To use the Price APT equation.2: Obtaining factor models or SDEs for tradables.

I could solve the equations for λ0 and λ1 . what if things aren’t so perfect. The Price APT equation says there needs to exist λ0 and λ such that Am A = = Pm λ0 + B m λ Pλ0 + Bλ. followed by pricing the new derivative.7) which is the pricing equation for the derivative. we use the marketed tradables to determine the market prices of risk.2 Pricing the Derivative Now we can use the Price APT to price the derivative. and the tradable without any subscript is the derivative that we are pricing.6) to find the market prices of risk (often in terms of information from the marketed tradables).4) and use it to illustrate pricing.9) ct + µScS + σ 2 S 2 cSS = r0 c + 2 σ Rearranging this gives 1 (5. Thus. we only use the marketed tradables. we designate the bond B and stock S as being the marketed assets. and c is the derivative that we would like to price. Thus. . Using marketed tradables to determine the market prices of risk is like calibrating parameters (market prices of risk) in our absence of arbitrage pricing model to known data (marketed tradables). The market prices of risk are then plugged into (5. the price APT implies that       r0 B 0 B  S  λ0 +  σS  λ1 =  . If we specify the boundary condition for a European call option as c(S. (5. Thus.5. c(0.7) To obtain the market prices of risk λ0 and λ. It was perfect! Now. (5. Once our model is calibrated (the market prices of risk are determined).5. Let use an example. One may think of this procedure as first calibration to market data.10) ct + r0 ScS + σ 2 S 2 cSS = r0 c 2 which is the Black-Scholes partial differential equation for the price of an option. A picture of the application of the Price APT is given in Figure 5. Assume that c is a European call option on the stock S.5. so let’s see an example Example: Pricing a European Call Option Let’s take the tradables table in (5. That is. T ) = (S − K)+ . we use these market prices of risk in the third equation for our derivative to obtain µ − r0 1 σScS (5.11) 5.5. First. Then. 5.3. t) = 0 then this completely describes the price of the option. we solve (5. APPLYING THE PRICE APT 45 The tradables with the subscript m are the marketed tradables. Solving these equations gives λ0 = r0 and λ1 = µ−r0 . what if the system of equations arising from the Price APT for the marketed tradables is either underdetermined or overdetermined.3 Underdetermined and Overdetermined Systems In the example above everything was perfect! I had two equations (one for the bond and one for the stock). σ Finally.8) 1 2 2 σScS c ct + µScS + 2 σ S cSS where the top two rows correspond to the marketed tradables. This discussion has been a little abstract.6) (5. we can apply our absence of arbitrage model to price other tradables (derivatives) that also must satisfy the same absence of arbitrage relationship. and two unknowns (the market price of time λ0 and the market price of risk λ1 ) corresponding to the marketed tradables. µS (5.

Thus. it only provides a unique price if we have unique values for the market prices of risk. there are many possible market prices of risk that satisfy the no arbitrage condition. we cannot uniquely infer the market prices of risk for dz1 and dz2 . This situation is called an incomplete market. and all are arbitrage free. The practical consequence of this is that if we are asked to price a new security that depends on dz1 and/or dz2 . we can’t uniquely solve for the market prices of risk! (In this case.46 CHAPTER 5. Let’s assume that many solutions exists. CONSTRUCTING A FACTOR PRICING FRAMEWORK Figure 5. Since market prices of risk relate risk to reward for various factors. we can solve for λ0 = r0 . there are multiple possible values for λ1 and λ2 . For example in the above equations. the price APT becomes B S 0 σ1 S 0 σ2 S  λ0  λ1  = λ2  r0 B µS (5. we will not be able to assign it a unique absence of arbitrage price. Incomplete markets are common in practice.14) = r0 Bdt = µSdt + σ1 Sdz1 + σ2 Sdz2 . but only two equations! Thus. but not uniquely for λ1 or λ2 . we must select values for market prices of risk that are not uniquely defined. and λ2 ). and you will see in subsequent chapters that in order to price derivative securities in incomplete markets. (This use will become clear in the following chapters. we just need for at least one solution to exist). This just means that from the tradable assets in the market (B and S). This is because the APT equation (in either return or price form) acts as a pricing equation. (5. selecting a value for .12) (5. This is guaranteed by the APT equations. then there is no arbitrage.) What can we say in this situation and how should we think of this? Well. we can say that if any solution exists (it doesn’t have to be unique. λ1 .3: A picture of the application of the Price APT.) However. There are many possibilities. first.13) And we have three unknowns (λ0 . Underdetermined and Incompleteness Assume that our assets are given by dB dS In this case.

6 Three Step Procedure To summarize. Write factor models (SDEs) for each tradable asset (this may involve Ito’s lemma). S1 and S2 are not perfect. and then to the derivative using those market prices of risk (this usually results in a partial differential equation for the price). (See Figure 5. you might want to return to this discussion after reading subsequent chapters.15) (5. The three steps are: 1. the price APT becomes  B  S1 S2  0 σ1 S  σ2 S λ0 λ1  r0 B =  µ 1 S1  µ 2 S2  (5. However. jump-diffusion models or stochastic volaility).18) = r0 Bdt = µ1 S1 dt + σ1 S1 dz = µ2 S2 dt + σ2 S2 dz. for an overdetermined system of equations no solution will exist! What does this mean? Well. there is an arbitrage opportunity! But. (See Figure 5.1.6.16) (5. In practice this situation often leads to some sort of calibration procedure.3.) 3. Instead of declaring that an arbitrage exists. the way this situation often plays out in practice is usually slightly different. (See Figure 5. let’s present a three step procedure to deriving a derivative pricing equation. the first thing it means is that strictly speaking. underlying variables. Overdetermined and Calibration Now let’s consider the opposite situation.17) In this case there are three equations and only two unknowns (λ1 and λ2 )! This system looks to be overdetermined! Now. and construct a tradables table. Apply the Price APT equation. the trader will search for the λ1 and λ2 that best fit the absence of arbitrage equations. The above discussion might be a little abstract at this point. and that is the reason that no solution exists. a trader will often just assume that the models being used for B.5. Thus. They often call this process calibration. THREE STEP PROCEDURE 47 a market price of risk is essentially the same as specifying how investors in the market trade off risk and return. and factors in a model. (5. That is. and in practice it may be difficult to recognize directly as searching for best fit λ’s. we know from the price APT that for no arbitrage to exist there must exist a solution to this set of equations. Furthermore. in general. in incomplete markets some specification of the risk preferences of investors is needed to assign a unique price to derivative securities. or when certain models are fit to volatility smiles and smirks. let the tradable assets be dB dS1 dS2 In this case. this specification of risk preferences is captured by the selection of the market price of risk.) Again. 5. For example. first to the marketed tradables in order to solve for the market prices of risk (calibration). Thus. (Watch for it in situations such as term structure modeling where a single factor dz is used. when the set of equations is overdetermined.) .) 2. Identify the tradable assets. but many tradables (bonds of different maturities) exist.2. but in subsequent chapters you might want to refer back to it when faced with pricing of derivatives in incomplete markets (see for example.

then identify the factors.2 (A Single Factor Short Rate Model) Let r0 (t) denote the short rate of interest. and assume that it follows dr0 = adt + bdz (5. Also assume that a bond dB = r0 Bdt (5. In the next chapter we tackle examples in equity derivatives. then identify the factors.8. Problem 5. . I will also often sweep that under the rug. I will consider the limited scope of just deriving partial differential equations for pricing. This cookie cutter approach will allow us to derive many of the partial differential (or difference/integral/etc. Furthermore. CONSTRUCTING A FACTOR PRICING FRAMEWORK In this book.19) Problem 5. we have provided a three step procedure for deriving the pricing equation for a derivative security based on the linear factor approach. and in the following chapter we address interest rate derivatives. 5.1 (A Stock Paying Continuous Dividends) Consider a stock S(t) following dS = µSdt + σSdz that pays a continuous dividend at a rate of q. and I will sometimes leave out the important step of actually solving the pde!! Furthermore. assume that a money market account exists that satisfies dB0 = r0 (t)dB0 dt (5. and create a tradables table.8 Problems (5.) equations that arise in derivative pricing theory.48 CHAPTER 5.22) In this model. Let these bonds be a function of the short rate and time t. underlying variables.8.21) Assume that zero coupon bonds of maturity T are tradables and the price at time t is denoted by B(r.7 Summary In this chapter.20) exists. 5. t|T ). t) is a European call option on the stock. and merely note that a particular derivative security will correspond to the solution of the pde with a particular boundary condition. If c(S. often many different derivative securities satisfy the same basic pde and only differ due to their boundary condition. and create a tradables table. What you should take away is that simple arbitrage ideas that we derived in this chapter are the underpinnings of derivative pricing theory. underlying variables.

1 dc = (ct + µScS + σ 2 S 2 cSS )dt + σScS dz. (6.1. this allows us to move on to Step 3. By Ito’s lemma.1) (6. we consider a derivative on the stock.3) Solving for λ0 and λ1 using the first two equations gives: λ0 = r0 The tradable table contains all the information we need to apply the Price APT equation. the tradable assets are the stock S. which is to solve the Price APT equation Pλ0 + Bλ1 = A for absense of arbitrage conditions. µS d S  =  (6. bond B.Chapter 6 Application of the Factor Form: Equity Derivatives The factor approach to absence of arbitrage pricing is one of the quickest and most direct routes to deriving pdes for derivatives. Hence. t) and is twice continuously differentiable in both its arguments.1 Examples from Equity Derivatives Black-Scholes Black and Scholes started everything with this model [2].  S  λ0 +  σS  λ1 =  µS (6. and the derivative c. 6. In this chapter we will see that it can be used to derive almost every Black-Scholes type pde that occurs in derivative pricing.5) 1 2 2 c σScS ct + µScS + 2 σ S cSS λ1 = 49 µ − r0 . Generically we call this derivative c and assume that it’s price process depends on the stock and time c(S.4) 1 c c σScS ct + µScS + 2 σ 2 S 2 cSS (6.2) Furthermore. σ Therefore. The standard Black-Scholes set-up involves a bond earning a risk free rate and a non-dividend paying stock that follows a GBM: dB dS = = r0 Bdt µSdt + σSdz. 2 (6.1 6.       r0 B 0 B . We can now move to Step 2 and construct a tradable table         r0 B B B 0  S   dt +  σS  dz.6) .

22) . t) = SN (d1 ) − Ke−r0 (T −t) N (d2 ) A European put option is a derivative security p(S. t) with boundary conditions p(S.10) (6. The assumption of a continuous dividend at a rate of q is equivalent to assuming that the number of shares N (t) grows according to the equation dN = qN dt. T ) = max(S − K. Let N (t) denote the number of shares held of this stock at time t.13) (6. t) The solution is d1 d2 = = ln(S/K) + (r0 + 1 σ 2 )(T − t) 2 √ σ T −t √ d1 − σ T − t (6.14) = = = max(S − K. the option is worth c(S. t) = Ke−r0 (T −t) N (−d2 ) − SN (−d1 ) 6.9) (6.16) (6.18) (6.50 CHAPTER 6. 0) −r0 (T −t) (6.15) t ∈ [0. 0) where K is the strike price. T ] (6.7) Finally. T ) p(0. 2 European Call and Put Options For a European call option. c(S.21) What we purchase is a single share of this stock.8) ∞ t ∈ [0. rearranging leads to the Black-Scholes equation: 1 ct + r0 ScS + σ 2 S 2 cSS = r0 c. T ] c(S.1. Then the stock and its dividend stream is a tradable asset. Let’s assume the stock price follows dS = µSdt + σSdz.11) (6.17) 0 Ke 0 t ∈ [0. T ) c(0. σ 2 (6.2 Dividend Paying Stocks Let’s assume that the stock is paying a continuous dividend at a rate of q. Hence we must consider them together as a tradable asset. 0) 0 t ∈ [0. (6.12) (6. t) = ∞. That is. we are also purchasing its dividend stream. t) p(∞. t) c(∞. T ] The solution to the Black-Scholes equation under these boundary conditions is d1 d2 = = ln(S/K) + (r0 + 1 σ 2 )(T − t) 2 √ σ T −t √ d1 − σ T − t (6. T ] (6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES Plugging λ0 and λ1 into the last equation yields r0 c + 1 µ − r0 σScS = ct + µScS + σ 2 S 2 cSS . the boundary condition is that at expiration T .20) p(S. when we purchase the stock.19) (6. We also have the boundary conditions that c(0. t) = = = max(K − S. t) = 0 for all t and limS→∞ c(S. (6.

the portfolio with value N (t)S(t) changes to N (t)S(t) → = = (N (t) + dN )(S(t) + dS) N (t)S(t) + dN S(t) + N (t)dS + dSdN N (t)S(t) + qN (t)S(t)dt + µN (t)S(t)dt + σN (t)S(t)dz + o(dt). rearranging leads to the Black-Scholes equation: 1 ct + (r0 − q)ScS + σ 2 S 2 cSS = r0 c.31) λ1 = µ + q − r0 . Only tradable quantities appear in the tradables table. and only those quantities need to satisfy the absence of arbitrage conditions. the payoff of the option depends on the price of the stock alone. (6. a moment of thought more. 51 (6. For instance. and does not depend on the dividend stream. we assume c = c(S.1. foreign currencies that are invested in a money market account are essentially a security that earns a continuous dividend. the point is.29) c σScS ct + µScS + 1 σ 2 S 2 cSS 2 Solving for λ0 and λ1 gives: λ0 = r0 and plugging λ0 and λ1 into the last equation gives r0 c + 1 µ + q − r0 σScS = ct + µScS + σ 2 S 2 cSS . Finally. 2 What does this apply to? At first thought.30) Finally.  v  λ0 +  σv  λ1 =  µv (6. (µ + q)v d v  =  1 2 2 c c σScS ct + µScS + 2 σ S cSS (6. So can a commodity with a convenience yield. EXAMPLES FROM EQUITY DERIVATIVES Then over time dt. t) and apply Ito’s lemma to c to obtain 1 (6. we consider v(t) the tradable.32) . σ 2 (6.28) Note that the stock price alone S(t) does not appear in the tradable table since it is not tradable. Now. Therefore. we consider the option. 2 The next step is to write the tradable table         r0 B B B 0  v   dt +  σv  dz. σ (6.24) (6.6. (6. we realize that it is a decent approximation for a number of financial situations.       r0 B B 0 . a continuous model for a dividend does not seem too realistic.27) dc = (ct + µScS + σ 2 S 2 cSS )dt + σScS dz. don’t let the notation of calling S a ”stock” limit your thinking about how these models can be applied.23) (6.25) If we denote the value of the share with its dividend stream by v(t) = N (t)S(t) then we have dv = v(t + dt) − v(t) = (µ + q)v(t)dt + σv(t)dz. The final step is to solve the Price APT equation Pλ0 + Bλ1 = A. However.26) Hence. a stock index with many stock that pay dividends at different times can be approximated as a continuous dividend. So. Moreover.

we can once again use our three step procedure. which causes c to drop by exactly D.39) . The solution is d1 d2 1 ln(S/K) + (r0 − q + 2 σ 2 )(T − t) √ σ T −t √ = d1 − σ T − t = (6.38) I have not described how to apply Ito’s lemma in this situation before.52 CHAPTER 6. and we apply Ito’s lemma to obtain 1 dc = (ct + µScS + σ 2 S 2 cSS + (c(S − − D. Therefore. (6. Once again. Now. since they have discrete jumps.37) where δ(t − τ ) is a dirac delta function at time τ . v. we model the stock price as dropping by D exactly at the time τ . t))δ(t − τ ) The final step is to solve the Price APT equation       r0 B B 0   v  λ0 +  σv  λ1 =  µv 1 2 2 − − c σScS ct + µScS + 2 σ S cSS + (c(S − D. Call this value v(t). and now we can write the tradables table. and with this we will get the stock price plus the dividend. This entire stream together it what is tradable. This notation is just to indicate that the price drops by exactly D at time τ . we assume that the stock pays a dividend at the time τ in the amount of D. we will use dirac delta notation and write it as dS = (µS − Dδ(t − τ ))dt + σdz (6. To model this.35) c(S. Of course. at time τ the jump occurs. t))δ(t − τ ))dt + σScS dz 2 (6. and after the jump time τ . since we know exactly when the jump will occur. t) is a derivative security. we consider that the value corresponding to a single share is continuous and follows a geometric Brownian motion. t) = Se−q(T −t) N (d1 ) − Ke−r0 (T −t) N (d2 ) Note that this is very similar to the formula for a European call option on a non-dividend paying stock. it is even simpler.1. t) − c(S . except that q shows up in a couple of places.         r0 B B B 0  v   dt +  σv  dz µv d v  =  1 2 2 − − c c σScS ct + µScS + 2 σ S cSS + (c(S − D.33) (6. However. The above equation just indicates that we use Ito’s lemma for Brownian motion up to. We often call this either a cash or lump dividend. but this time on a stock that pays a continuous dividend.3 Cash Dividends Most individual stocks pay a prespecified dividend at a prespecified time. 6. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES European Call Option Once again. the delta function δ(t − τ ) is really just used to indicate that a jump occurs at time τ .42) differs from the non-dividend Black-Scholes equation only slightly. To compute the equation satisfied by an option on a stock that pays a cash dividend prior to expiration. t) − c(S . Therefore. t) − c(S − . we assume that c(S. However. and c.34) (6. To model this drop.36) Now. t))δ(t − τ ) (6. we have identified the tradables B. the bond is a tradable. we can purchase a share of the stock. you may recognize that this situation is very similar to a process driven by a Poisson process. where it satisfies dv = µvdt + σvdz. since (6. Now. we can consider the value of a European call option. This is too be expected. In this case.

my tradables are dB dS dc = = = r0 Bdt (µS + ν(k − 1)S)dt + (k − 1)S(dπ(ν) − νdt) (ct + µScS + ν(c(kS − ) − c(S − )))dt + (c(kS − ) − c(S − ))(dπ(ν) − νdt) (6. k−1 (6. In this case.4 Poisson Processes This was done by Cox and Ross [5]. (6. Furthermore.40) (6.49) µ − r0 + ν (c(kS − ) − c(S − )) = ct + µScS + ν(c(kS − ) − c(S − )) k−1 (µ − r0 ) (c(kS − ) − c(S − )) = (k − 1) (ct + µScS − r0 c) . t) − c(S − . This set-up involves a bond earning a risk free rate and a non-dividend paying stock that follows a geometric Poisson motion (GPM): dB dS = = r0 Bdt µS dt + (k − 1)S dπ(ν) − − (6.6.41) (6.43) (6.50) Finally.51) .46) (6. Generically we call this derivative c and assume that its price process depends on the stock and time c(S. I would like to write my factor equations such that the factors are pure risk and don’t have any mean drift. ν). EXAMPLES FROM EQUITY DERIVATIVES Solving for λ0 and λ1 gives: λ0 = r0 Plugging λ0 and λ1 into the last equation yields µ − r0 1 σScS = ct + µScS + σ 2 S 2 cSS + (c(S − − D. Hence. which is to solve the Price APT equation Pλ0 + Bλ1 = A for absence of arbitrage       r0 B 0 B .47) (6.44) where ν is the intensity of the Poisson process π(t. 2 λ1 = 53 µ − r0 σ (6. t))δ(t − τ ) = r0 c. we consider a derivative on the stock. By Ito’s lemma. t) − c(S − .  λ1 =   S  λ0 +  µS + ν(k − 1)S (k − 1)S ct + µScS + ν(c(kS − ) − c(S − )) c(kS − ) − c(S − ) c Solving for λ0 and λ1 gives: λ0 = r0 Plugging λ0 and λ1 into the last equation yields r0 c + λ1 = µ − r0 + ν.42) 6.48) We can now construct a tradables table   B  S  c      B r0 B 0  dt +   (dπ(ν) − νdt) µS + ν(k − 1)S (k − 1)S d S  =  c ct + µScS + ν(c(kS − ) − c(S − )) c(kS − ) − c(S − )  This allows us to move on to Step 3.1.1.45) This is a case where the random factor does not have zero mean. rearranging leads to the Black-Scholes equation: r0 c + 1 ct + r0 ScS + σ 2 S 2 cSS + (c(S − − D. rearranging leads to the equation: (6. dc = (ct + µScS )dt + (c(kS − ) − c(S − ))dπ(ν). I will compensate the factor in order to give it zero drift. t) and is continuously differentiable in both its arguments. t))δ(t − τ ) σ 2 Finally. (6.

57) d f  =  1 c c σf cf ct + µf cf + 2 σ 2 f 2 cf f Recall that the futures contract was the special case that motivated us to consider the price approach to absence of arbitrage. The key point was that the mark-to-market mechanism always sets the price of a futures contract to zero while the change in value of the contract over period dt is given by the change in the futures price df . Let’s derive the pde satisfied by an option on a futures contract.55) Furthermore. t) = SΨ(x. y/k) where Ψ(α. 1 (6.54) (6.1. β) = i=α ∞ (6. i! y= (r0 − µ)(T − t)k k−1 and x is the smallest non-negative integer greater than ln(K/S)−µ(T −t) . 2 We can now complete Step 2 and construct a tradables table         r0 B B B 0  0   dt +  σf  dz.58) 1 2 2 σf cf c ct + µf cf + 2 σ f cf f Solving for λ0 and λ1 gives: µ λ0 = r0 λ1 = . By Ito’s lemma. This corresponds to the tradable table we have written above.5 Options on Futures This was essentially done by Black in [1]. (6. we consider a derivative on the futures price.53) e−β β i . I will give the solution for a call option with strike K and expiration T : c(S. Assume there exists a bond and a futures contract with futures price f given as dB df = = r0 Bdt µf dt + σf dz.61) 2 . 6. one can interpret it as the Black-Scholes formula.       r0 B 0 B  0  λ0 +  σf  λ1 =   µf (6. t) and is twice continuously differentiable in both its arguments.52) (6. (6. but with a Poisson random variable replacing the Gaussian random variable. rather than working with returns. This allows us to move on to Step 3. Generically we call this derivative c and assume that it’s price process depends on the futures price and time c(f. In fact.54 CHAPTER 6. µf (6.59) σ Plugging λ0 and λ1 into the last equation yields 1 µ (6. ln(k) Note that this solution has a structure that is very similar to the Black-Scholes fomula. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES European Call Option One can actually find a closed form solution for European call and put options in this model. which is to solve the Price APT equation Pλ0 + Bλ1 = A for absense of arbitrage.56) dc = (ct + µf cf + σ 2 f 2 cf f )dt + σf cf dz. y) − Ke−r0 (T −t) Ψ(x. rearranging leads to the partial differential equation: 1 ct + σ 2 f 2 cf f = r0 c. (6. σ 2 Finally.60) r0 c + σf cf = ct + µf cf + σ 2 f 2 cf f .

Yet. However. let’s proceed by considering ((c(Y S − ) − c(S − ))dπ − αE[(c(Y S − ) − c(S − ))]dt) and (Y − 1)dπ(α) − αE[Y − 1]dt as two different factors.1. By Ito’s lemma we have dc = Lcdt + σScS dz + (c(Y S − ) − c(S − ))dπ − αE[(c(Y S − ) − c(S − ))]dt where (6.6. The randomness associated with the jump term does not enter in the same way to S and c.71) Finally. we would rather not do this.62) (6. in this case that is not possible unless we consider c(Y S − ) − c(S − )dπ a new factor. t) is a function of S and t.72) . we can just plug into that formula to obtain the price of a European call option. This model is nice because it is related to many other models in equity and interest rate derivatives. For notational convenience.1.70) Then our tradables table is        0 r0 B B B  S  d  S  =  (µ + αE[Y − 1])S  dt +  σS σScS Lc c c (6.69) (6. EXAMPLES FROM EQUITY DERIVATIVES European Call Option 55 Note that the Black-Scholes equation in this case (6.65) (6. Merton originally solved this problem using a similar technique.67) 1 Lc = ct + µScS + σ 2 S 2 cSS + αE[(c(Y S − ) − c(S − ))] (6.66) where the jump portion of the stock has been compensated. and we will bypass the problem in the same manner that Merton did. The problem is how to identify factors. we would solve the Price APT equations        B 0 0 0 r0 B λ1  S  λ0 +  σS S 0   λ2  =  (µ + αE[Y − 1])S  c λ3 σScS 0 1 Lc (6. This is where we run into a problem. The solution is d1 d2 = = ln(f /K) + ( 1 σ 2 )(T − t) √ 2 σ T −t √ d1 − σ T − t (6.61). A derivative on the stock c(S. looks just like the Black-Scholes equation on a stock paying a continuous dividend. We will also find that this model creates a problem for our factor approach. t) = f e−r0 (T −t) N (d1 ) − Ke−r0 (T −t) N (d2 ). The model includes a risk free bond and an underlying asset that has a diffusion portion and a lognormal jump portion.63) (6. However. Here are the basic assets dB dS = = r0 Bdt (µ + αE[Y − 1])Sdt + σSdz + S − ((Y − 1)dπ(α) − αE[Y − 1]dt) (6. This model has a closed form solution for the derivative price which Merton computed in his original paper [11]. at this point we have no choice. Therefore. 6. however the continuous dividend rate is q = r.68) 2 Now we come to the point that we need to write a tradables table. since this risk is driven by the same Poisson process and jump size Y . We would like to be able to write down a linear factor model in the factors dz and Y dπ or a compensated version of of Y dπ.64) c(f.6 Jump diffusion A jump diffusion model was first solved by Merton [11]. Let’s get started. let’s call them dψ1 dψ2 = = (Y − 1)dπ(α) − αE[Y − 1]dt (c(Y S − ) − c(S − ))dπ − αE[(c(Y S − ) − c(S − ))]dt 0 S 0   dz 0 0   dψ1  dψ2 1 (6. So.

This is fairly messy and leaves a lot of degrees of freedom. This formula can be found in Merton’s work [11]. σ 2 + . conditional on the number of jumps. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES Now we can solve for the market prices of risk as. and γ = ln(1 + k). 2 Bankruptcy (6. Note the following counterintuitive observation. Y = 0. and the final equation becomes r0 c + which can be rewritten as Now. this model is really the prototype for defaultable bonds. λ′ = λ(1 + k). then the value of call option will actually increase! You should think about this carefully to understand why that is true. σ (6. We also have that k = E[Y − 1].74) µ + αE[Y − 1] − r0 σ σScS = Lc (6. The key is that under this jump diffusion model. This is a strong assumption! But let’s follow Merton and see where this leads us. r0 ) is the Black-Scholes formula for a European call option with strike K and expiration T on a non-dividend paying stock with current price S. Lognormal Jumps! When Y the jump size is lognormal. it is given by ∞ c(S.. (6. and there is a closed form solution to the pde for European call and put options. K. Note that it is basically a combination of the Black-Scholes formula and the solution under Poisson dynamics. the market price of risk of any risk associated with the jump term is zero! This is the same as setting λ2 = λ3 = 0. σ. and with risk free rate r0 .77) This looks like standard Black-Scholes but the interest rate has been increased by the default probability! We will see that this same relationship will also appear in defaultable bonds. Then the above equation becomes 1 ct + (r0 + α)ScS + σ 2 S 2 cSS = (r0 + α)c. This means that according to our model above. volatility σ. Merton doesn’t do this. t) = n=0 e−λ (T −t) (λ′ (T − t))n nδ 2 nγ cBS S. we can give a closed form solution in this case based on the Black-Scholes formula. r0 − λk + n! T −t T −t ′ (6. the Price APT equations Pλ0 + Bλ = A become       r0 B B 0  S  λ0 +  σS  λ1 =  (µ + αE[Y − 1])S  .73) Lc c σScS λ1 = µ + αE[Y − 1] .75) 1 ct + (r0 − αE[Y − 1])ScS + σ 2 S 2 cSS = r0 c − αE[(c(Y S − ) − c(S − ))]. T − t. K.76) Let’s consider a special case of complete bankruptcy. we can write out the full pde which will have a number of unknown market prices of risk. the price . With λ2 = λ3 = 0. That is. In fact. Instead he make the assumption that all jump risk is diversifiable. stock distribution at expiration is lognormal. For a European call option with strike K and expiration T .. the value of a European call option increases with the risk free rate. then conditional on the number of jumps that have occurred before expiration. if the rate of bankruptcy increases. 2 (6. λ0 = r0 . Of course. In the Black-Scholes formula.78) where cBS (S. That is.56 CHAPTER 6. T.

(6. which is Poisson. in this case. we have a Black-Scholes formula. indicating that the solution should look like Black-Scholes.81) (6.80) (6.85) In this case we have four equations and only three unknowns. EXAMPLES FROM EQUITY DERIVATIVES 57 distribution at expiration is log-normal. (6. Hence.86) λ0 = r0 λ1 = σ1 σ2 If we plug these into the final equation. Simple! 6. tradable assets will be called the bond B and two other assets S1 and S2 . the tradable table is   B  S1     S2  c   r0 B B  S1   µ 1 S1   d  S2  =  µ 2 S2 Lc c   0  σ 1 S1   dt +    0 σ 1 S1 c S 1  0  0  σ 2 S2  σ 2 S2 c S 2   0  0  σ 2 S2  σ 2 S2 c S 2  r0 B  µ S  =  1 1 . can a vanilla call option be thought of as exchanging one asset for another? What are the two assets being exchanged? Anyway.84) Finally. we obtain Lc = r0 c + which upon rearrangement becomes 1 2 2 1 2 2 ct + r0 S1 cs1 + r0 S2 cs2 + σ1 S1 cs1 s1 + σ2 S2 cs2 s2 + ρσ1 σ2 S1 S2 cs1 s2 = r0 c.82) 1 2 2 1 2 2 L1 c = (ct + µ1 S1 cS1 + µ2 S2 cS2 + σ1 S1 cS1 S1 + σ2 S2 cS2 S2 + ρσ1 σ2 S1 S2 cS1 S2 ) 2 2 and ρ is the correlation coefficient between z1 and z2 .6.88) µ1 − r0 µ1 − r0 σ 1 S1 c S 1 + σ 1 S1 c S 1 σ1 σ1 (6. Their dynamics are given by: dB dS1 dS2 dc where = = = = r0 Bdt µ1 S1 dt + σ1 S1 dz1 µ2 S2 dt + σ2 S2 dz2 L1 cdt + +σS1 cS1 dz1 + σS2 cS2 dz2 (6.1.83) dz1 dz2 . the answer is Black-Scholes. Thus. λ1 and λ2 as µ2 − r0 µ1 − r0 λ2 = .1. the solution is basically that conditioned on the number of jumps that have occurred. Therefore. Let’s use the first three equations to solve for λ0 .79) (6. we solve the Price APT equations    0 B  σ 1 S1  S1      S2  λ 0 +  0 σ 1 S1 c S 1 c λ1 λ2 (6. For instance. The only question is how many jumps have occurred. Why? because many other derivatives can be thought of as exchanging two different assets.87) .7 Exchange one asset for another Margrabe’s [10] exchange one asset for another is one of my favorite derivatives. 2 2 (6.  µ 2 S2  Lc  (6. for each possible number of jumps. then we need to weight them by the probability of that number of jumps.

58 CHAPTER 6. S1 S1 dividing S2 by S1 is essentially changing units in order to value S2 in units of S1 . S2 . in units of S1 . Our derivative can depend on S. Let’s look at the payoff S2 c(S1 .92) (6. Assume that you have the option to exchange asset S1 for asset S2 at time T . When we change units by denominating everything in terms of another asset (such as S1 in this case). 0. this is just a call option on S2 with strike 1! The multiplication on the left by S1 just converts the call option back to units of dollars. APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES Closed form solution There is a closed form solution for a European exchange one asset for another. 0). Needless to say. we call that a change of numeraire. we can list the relevant equations and we assume that z1 and z2 are correlated E[dz1 dz2 ] = ρdt.93) Note that this solution looks very much like Black-Scholes. the portion max( S2 − 1. the boundary condition is c(S1 . 0) looks like the payoff of a call option with strike 1 on the asset S2 ! In fact.8 Stochastic volatility dB dS dv = r0 Bdt √ = µSdt + vSdz1 = adt + bdz2 (6. Would I end up getting the wrong answer?) By Ito’s lemma we have: √ (6.1. Therefore.94) (6.97) dc = Lcdt + vScS dz1 + bcv dz2 √ 1 1 Lc = (ct + µScS + acv + vS 2 cSS + b2 cvv + ρb vScSv ) 2 2 In this case the tradables are dB dS dc = = = r0 Bdt √ µSdt + vSdz1 √ Lcdt + vScS dz1 + bcv dz2 where (6. S2 .91) (6. t).98) (6. t) = S2 N (d1 ) − S1 N (d2 ) where d1 d2 σ = = = 1 ln(S2 /S1 ) + 2 σ 2 (T − t) √ σ T −t √ d1 − σ T − t 2 2 σ1 + σ2 − 2ρσ1 σ2 . 0). t) = 0. we shouldn’t be surprised that the solution looks like Black-Scholes. and we call the asset S1 the numeraire asset.95) (6.99) (6. (What if I didn’t assume the derivative was a function of v? This would have been a bad assumption since I know in the Black-Scholes case that c is a function of the volatility. Therefore. t) = S2 . some problems (such as this one) are easier to solve in a convenient set of units. c(S1 . 6.89) (6. S1 Now. t. (6. 0) = S1 max( − 1. we write c(S. and v. because this is really just a call option in a different set of units. The closed form solution for this option is c(S1 .100) (6. Here is some intuition into why.96) First. Hence.90) (6. c(0. S2 . T ) = max(S2 − S1 . v. S2 .101) . Hence. T ) = max(S2 − S1 .

e.14) in this case.103) λ1 = µ − r0 √ .2 (The power of linearity (Breeden and Litzenberger)) We will use linearity to derive the formula for a European digital option in terms of a European call option price. Plugging these into the final equations leads to √ 1 1 ct + r0 ScS + (a − λ2 b)cv + vS 2 cSS + b2 cvv + ρb vScSv = r0 c 2 2 (6. t)). for a European call option. (If you plug in the Black-Scholes formula for c(S. Draw a picture of the payoff as a function of ST . We can think of the payoff of a European call option as a ramp function. t).) (e) As one final task.2. Lc (6. I won’t cover this in detail here. Note that if you have made it this far. (Hint: think of how you can construct the payoff of a digital option by buying and selling call options. and finally we price a dirac delta function. and pays nothing if it ends up below the strike price. See Heston [9] if interested. In particular. (a) Let T be the expiration date for the digital option. Problem 6. price a security whose payoff is (ST − K)2 for ST ≥ K and 0 for ST < K. t).6.104) Note that we leave λ2 as an unknown. Using only this information. this pde has a fairly convenient solution via transform methods. K. K. show that the exchange one asset for another formula (6. 6.2.102)  r0 B =  µS  .1 Show that the Black-Scholes formula (6.90) reduces to the Black-Scholes formula (6. v (6. (b) Assume that you know the price of European call options for every strike K for the expiration date T (i.) (c) Taking the above argument one step further. t) then you have the standard risk neutral pricing formula when the underlying asset follows a geometric Brownian motion.2 Problems Problem 6. (Here is a big hint if you are having trouble with this problem.2.14) is a special case of exchange one asset for another where one asset is the stock S(t) and the other is the bond B(t). PROBLEMS So the tradable table is  59 Solving for the market prices of risks λ0 and λ1 gives λ0 = r0 Finally. (6. K. we solve the Price APT equations    B √0  S  λ0 +  √ vS c vScS  B  S  c     B r0 B √0 d  S  =  µS  dt +  √ vS vScS c Lc  0 0  bcv λ1 λ2    0 0  bcv dz1 dz2 . (d) Use the result of (c) to derive a general pricing formula for an arbitrary payoff at time T. derive the price of a digital option with strike K in terms of c(S. A digital option looks like a step function. A digital option is an option that pays off 1 if the underlying stock ends up above the strike price K. step and delta function?) . What is the relationship between a ramp. K. derive the ”price” of a security whose payoff is a dirac delta function at K at expiration T . c(S. you have ”derived” the risk neutral pricing formula in terms of c(S.105) Under specific choices of a and b.

106) (6. (c) Using the Black-Scholes formula.107) where E[dz1 dz2 ] = ρdt and assume that a risk free asset exists with constant interest rate r. S2 . t. What equation must f (v. this pde can be in terms of a market price of risk. This is a derivative security with payoff c(S1 . That is. t) = S2 f (v.) . this option would give you the right to exchange it for S1 at time T . S2 . (e) (Margrabe) Consider an American option to exchange one asset for another (non-dividend paying again). the payoff is max(S1 − S2 . but at random times the market goes wild and the instantaneous variance jumps by an amount b. Again. After the jump. f . even on a non-dividend paying stock. if you currently hold S2 . write the pde from (a) in terms of S2 . for another S1 (assume they are non-dividend paying) at expiration T . t). Is it ever optimal to exercise this early? (f ) Merton showed that it can be optimal to exercise a put option early.60 CHAPTER 6. 0]. in which case.2. (c) Assume the payoff of a derivative security on a non-dividend paying underlying stock is a convex function that is non-positive when the stock is zero. (Hence. S2 . Problem 6. (Hint: your dynamics should look like: √ dS = µSdt + vSdz 2 dv = a(σl − v)dt + bdπ where π is a Poisson process with intensity α. Derive a parity relating S1 . The idea is that most of the time 2 the instantaneous variance is σl .2.3 All about Put-Call parity and Early Exercise. First write down the relevant dynamics for this problem. However.5 Consider a European call option on a non-dividend paying stock with stochastic volatility. 0). Is there a contradiction here? Problem 6. Derive this.4 (Exchange one asset for another) In this problem you will derive the formula for an option to exhange one asset for another by reducing the pde to a standard Black-Scholes pde for a call option on geometric Brownian motion. the instantaneous variance exponentially decays back to its normal level σl . Using these substitutions. (a) Let S1 and S2 be two assets whose dynamics are given by dS1 dS2 = = µ1 S1 dt + σ1 S1 dz1 µ2 S2 dt + σ2 S2 dz2 (6. T ) = max[S1 − S2 . t) satisfy? What is the appropriate boundary condition for a European option to exchange S2 for S1 in terms of the new variables.) (b) Consider the change of variable v = S1 /S2 and assume that the solution of the above pde is of the form c(S1 . and v. then derive a pde for the price of the option. this time we model the instantaneous variance with a Poisson process. we can think of a European put option as exchanging a stock for a bond.2. (d) Consider the European option to exchange one asset. the American counterpart would never be exercised early according to Margrabe. S2 and the options to exchange S1 for S2 and vice-versa. (b) Early exercise is not optimal for a standard American call option on a non-dividend paying stock. write down a formula for the value of an option to exchange S1 for S2 . Prove that if this is an American option. (a) Derive put-call parity for European call and put options on a non-dividend paying stock. But. it is never optimal to exercise early. Write down the pde for an option to exchange S2 for S1 at expiration T . APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES Problem 6.

Use the same parameter values as in part (a) (i.3.7 (American Options) Use the results of Chapter 4. T. and compute implied volatility curves. expiration T . and σ = 0. Once again plot the resulting implied volatility curve.2. r0 .1. T = 0.6 (Matlab Exercise) This exercise will introduce you to the implied volatility curve. r = 0. then assume that they represent market prices and plot the resulting implied volatility curve as a function of K.6. S(0) = 1.2]. you will generate prices under Merton’s jump-diffusion model.05. PROBLEMS 61 Problem 6. In this exercise. Problem 3 to derive the pde conditions followed by an American call or put option where the underlying stock (non-dividend paying) and bond follow dS dB = = µSdt + σSdz r0 Bdt. and also jump intensity of λ = 2. Use an initial stock price of S(0) = 1. T. and a risk free rate of r = 0. b. If cm is the market value of a call option with strike K.05.3). . first compute the Black-Scholes price of options using σ = 0. a. expiration of T = 0. K.3.108) is known as the implied volatility. Then the value of the volatility parameter σimpl that satisfies cm = cBS (S. For a range of strike prices from K = [0. jump mean of νJ = 0 and jump standard deviation of σJ = 0. This time. and if cBS (S.8. 1. σ) (assuming the stock is non-dividend paying) is the Black-Scholes formula for a European call option.2. You should see a slight implied volatility ”smile”! Problem 6.3. σimpl ) (6.e.2. use Merton’s jump-diffusion model to to generate the market prices. K. r0 .

APPLICATION OF THE FACTOR FORM: EQUITY DERIVATIVES .62 CHAPTER 6.

in many equity derivative models the market is either complete in which case the calibration phase of determining λ is simple. then pricing a derivative just proceeds by solving the appropriate pde with boundary conditions using the calibrated λ. they are really the same thing. That is. Because calibration is so important in interest rate and term structure models.Chapter 7 Application of the Factor Form: Interest Rate and Credit Derivatives In this chapter. the truth is that some of these models (such as HJM) are better suited for the risk neutral approach to derivative pricing (A subject that is touched upon in Chapter 9) simply because the pdes that we obtain are often too large and difficult to solve in any reasonable manner. For many equity derivatives. For any derivative pricing problem. 7. in what follows. λ0 . (Note that the notation is similar to the constant risk free rate r0 used in the previous chapter. the first challenge before being able to price a derivative is the calibration phase as in Figure 5. many marketed tradables. Let’s start with the short rate process.. or the market is incomplete in which case the APT equations are underdetermined and one is left with a degree of freedom in choosing λ. the calibration phase does not play prominently into the analysis. just described using a different ”language”. we apply the factor approach to interest rate and credit derivatives. This is because the short rate plays the same crucial role as the constant risk free rate in that it defines the market price of time. Hopefully.. Nevertheless.3 of Chapter 5. Before getting started. Beyond this. However. Once calibration is done. we may use a single factor. However in practice we simply recognize that our model is too simple and try to find a best-fit λ). the emphasis is showing that the pdes describing derivative pricing can all be easily derived from the simple factor approach equations. Okay. but have many. This makes the APT equations overdetermined! Thus. the calibration phase is in determining λ values that best fit all the marketed tradables (In theory if there isn’t a perfect fit. Interest rate and term structure models tend to be the opposite. then an arbitrage is available. I should also mention that ”calibration” in risk neutral pricing often looks different from what I have called the calibration phase (which is just determining the market prices of risk from the marketed tradables). we will often bring the models up to the point of calibration. let’s get to pricing. Since I have mentioned risk neutral pricing. let’s make a few comments about interest rate modeling and derivatives. The short rate r0 (t) is the interest rate earned from time t to time t + dt quoted using continuous compounding. at the end of your studies of derivative pricing you will be able to ”translate” between them. we will need to establish some notation. In fact. Again. it is extremely instructive to see that they can be understood via the factor approach. but not consider specific derivatives after that point.1 Notation and the Money Market Account In dealing with bonds and interest rate derivatives.) 63 .

That is.4) . Pay careful attention to the role that the money market account plays in what follows. 7. Furthermore. so don’t always assume that a variable is a constant if no arguments are explicitly listed. and continue this.1. Hence. B(r0 .2 7. That is. Vasicek [15] was the first to recognize that pricing with absence of arbitrage was possible by modeling the instantaneous short rate. We assume that the zero coupon bonds are functions of the short rate. Hence.2) where the time dependence is supressed in r0 = r0 (t). Hence. the short rate r0 (t) describes the instantaneous return on the money market account.64CHAPTER 7.2. we can write dB0 dB(T ) = = r0 B0 dt 1 (Bt (T ) + aBr (T ) + b2 Brr (T ))dt + bBr (T )dz 2 (7. t|T ). When convenient. The short rate process is important because it can be used to drive the entire spot rate curve.1 Interest Rate Derivatives Single Factor Short Rate Models The simpliest interest rate derivative model has a single underlying variable: the short rate. we define the money market account B0 (t) as the value of an account that is continuously rolled over at the instantaneous short rate.1) The money market account often plays a special role in interest rate derivatives because its dynamics are not explicitly driven by a random factor. t) can be functions of r0 and t. we will suppress these arguments. the money market account B0 (t) follows the dynamics dB0 (t) = r0 (t)B0 (t)dt (7. we will model this short rate variable as dr0 = adt + bdz (7. Figure 7.3) (7. this variable is driven by a single factor. then you reinvest that amount over the next dt at the rate r0 (t + dt). Note that this is the case even though r0 (t) itself can be random and follow a stochastic differential equation of its own. these models are typically called single factor short rate models.1: The Short Rate Process Furthermore. t). APPLICATION OF THE FACTOR FORM:INTEREST RATE AND CREDIT DERIVATIVES On a plot of the term structure.2. which we denote by B0 and zero coupon bonds with face value of $1 of varying maturity that we denote by B(t|T ) where t is the current time and T is the maturity date. Then suppressing arguments. This is pictured in Figure 7. you invest your money at the rate r0 (t) over the next dt. The tradables are a money market account. b = b(r0 . the short rate is where is spot rate curve intersects the y-axis as in Figure 7. and a = a(r0 .

(Thus. t)dt + g(X. we solve the Price APT equations B0 B(T ) λ0 + 0 bBr (T ) λ1 = r0 B0 1 (Bt (T ) + aBr (T ) + 2 b2 Brr (T )) (7. and Br . So. 7. and thus this is interpreted as a calibration phase. since in general we have many bonds. Now let’s write down the tradable table: B0 B(T ) d B0 B(T ) = r0 B0 1 (Bt (T ) + aBr (T ) + 2 b2 Brr (T )) dt + 0 bBr (T ) dz (7. r0 (X. it is possible to choose r0 (X. Thus. we can use a multifactor model as follows. floors. respectively.) We then assume that the short rate is a function of the underlying variables X. instead of using a single factor model. Note that one possibility is to have the short rate be one of the variables in X. we are treating all the bonds as being marketed tradables. t)dz (7. different bonds will often give different values of λ1 . etc. t) ∈ Rn .2. In particular. This equation must hold for zero coupon bonds of any maturity. any one of them should allow us to solve for λ1 .7. That is. Let X be a vector in Rn of underlying variables affecting the term structure. After this calibration phase.2: Notation for Zero Coupon Bond Prices where Ito’s lemma was used to derive the equation for dB(T ). Note that it is in terms of a market price of risk.2. t) ∈ Rn×n and f (X. Then the second equation gives 1 (Bt (T ) + (a − λ1 b)Br (T ) + b2 Brr (T )) = r0 B(T ) 2 (7.2 Multi-Factor Short Rate Models The single factor short rate models are usually not good enough to describe the term structure well. not that for convenience when using this partial derivative notation we supress the subscript r0 and write Br = Br0 . t) = X i . bond options. In practice.7) The boundary condition is of course that B(T |T ) = 1. t). g(X. When one tries to determine a single best fit λ1 from the bond data. represent the first and second partial derivatives with respect to the short rate r0 . . Brr .6) The first equation gives λ0 = r0 which is the random short rate.8) where z ∈ Rn is a vector of uncorrelated Brownian motions.5) Finally. We assume that these variables follow a stochastic differential equation model dX = f (X. INTEREST RATE DERIVATIVES 65 Figure 7. where X i is the i − th factor. one could then use this model to price other interest rate derivatives such as caps. In fact. indicating that the model is not exactly correct.

t) Bt (T )+BX (T )f (X. and given that it describes bonds as a function of λ. t (7. t) which is the random short rate.66CHAPTER 7. t)B0 0 dz dt + 1 Br (T )g(X.11) ∂ ln(B(t|T )).13) This model is a bit more complicated than the previous single and multi-factor short rate models because we see through equation (7. (7. Then the second equation gives 1 (Bt (T ) + BX (T )(f (X. This calibration can be quite difficult because bond prices are described by a pde. we have B0 B(T ) λ0 + 0 BX (T )g(X. to derive the pde that zero coupon bonds would follow. t|T ).2. Thus. they would appear as infinite dimensional pdes! Nevertheless. t)B0 1 (Bt (T ) + BX (T )f (X. APPLICATION OF THE FACTOR FORM:INTEREST RATE AND CREDIT DERIVATIVES Now. we might have to solve the pde every time.10) The boundary condition is of course that B(T |T ) = 1. and a zero coupon bond with maturity T seen from time t will be denoted by B(t|T ) and related to the instantaneous short rates by T B(t|T ) = exp − Hence.11) that B(t|T ) is a function of an infinite number of underlying variables r(t|s) for s ∈ [t. t) + 2 T r[BXX (T )g(X. t) − g(X. With this notational convention.12) HJM takes the instantaneous forward rates as the underlying variables. 7. t)λ) + T r[BXX (T )g(X. Via Ito’s lemma. t)B(T ) 2 (7. then we can quickly adjust λ to best fit the market data of bonds. t)]) = r0 (X. and models them as dr(t|s) = µ(t|s)dt + σ(t|s)dz(t). let r(t|s) denote the instantaneous forward rate seen from time t of the forward interest rate between time s and s + ds. This can be a pretty complicated pde. instead of modeling the instantaneous short rate as driving the term structure. t)]) (7. instead of using a generic Ito’s lemma relationship between B(t|T ) and the underlying factors r(t|s). Why is this helpful? Because this will allow us to pull the Price APT relationship for the marketed tradables B(t|T ) back to the underlying variables r(t|s) which opens up the possibility of doing calibration .9) where λ ∈ Rn . we also have that r(t|T ) = − r(t|s)ds . bond prices) to calibrate λ. we will be able to make that relationship concrete by plugging in explicit partial derivatives into Ito’s lemma. by the price APT. and to test the fit for different values of λ. we just note that bonds are a function of X and t. we have that the instantaneous short rate is given by r(t|t) = r(t). Hence. t)+ 2 T r[BXX (T )g(X. our tradables become B0 B(T ) d B0 B(T ) = r0 (X. The first equation gives λ0 = r0 (X. t) λ= r0 (X. t)] where I have suppressed the X and t arguments in B. It is much easier if the solution to the pde is known in closed form as a function of λ. if we were to write pricing formulas for derivatives.11) gives us an explicit relationship between the tradables and the (inifinite) underlying variables. ∂T (7. they decided to model instantaneous forward rates. Now. we have B(X. t)g T (X.3 Heath-Jarrow-Morton In the Heath-Jarrow-Morton [6] framework. we could use the current term structure (or equivalently. T ]! Because of this. t)g T (X. this model has an advantage over the previous single and multi-factor short rate models in that equation (7. That is. t)g T (X.

to complete our computation of Ito’s lemma.n}. let’s begin by assuming that s is indexed by k = 1.. INTEREST RATE DERIVATIVES 67 Figure 7. T ] through the equation T B(t|T ) = exp − r(t|s)ds t (7.e. let us think B(t|T ) = B({r(t|sk ) : k = 1. by Ito’s lemma. T ) will only depend on n Ito processes. t|T ) Then. and Br(t|si )r(t|sj ) using . In this setup. then this can simplify the calibration process. To understand the value of this. That is.7.3: Notation for Zero Coupon Bond Prices directly on the underlying factors r(t|s) instead of the marketed tradables. and compare that with using forward rate data to calibrate in the HJM model that we will derive.2. let’s dive into the details.14) To simplify our thinking. si )Br(t|si ) + i=1 j=1 i=1 1 σ(t|si )σ(t|sj )Br(t|si )r(t|sj )  dt 2 n  + σ(t|si )Br(t|si ) dz i=1 Now. we need to compute Bt . which means that we need to calculate dB(t|T ) for our tradables table.. we would have  n (7. no closed form solution to the pricing pde is known). We will derive the Price APT equations marketed tradables which are the bonds B(t|T ). However. with those preliminaries out of the way. That is.. B(t|T ) are tradables.n so that B(t. using the explicit relationship between the bonds B(t|T ) and the underlying variabels r(t|s) will allow us to pull the Price APT relationship back to the underlying variables r(t|s) which would then allow us to calibrate using r(t|s) directly. Okay. This is a bit of a tricky calculation because B(t|T ) is really a function of an infinite number of Ito processes r(t|s) for s ∈ [t. Br(t|si ) .15) n n dB = Bt (t|s) + µ(t. If it is easier to work with market data about instantaneous forward rates.. we will take zero coupon bonds as our marketed tradables. you should consider the calibration procedure that has to be done for a single or multi-factor short rate model if no closed form bond pricing formula is known (i.

taking the partial derivative with respect to T gives T µ(t|T ) − σ(t|T ) σ(t|s)ds = σ(t|T )λ1 t (7.16) T Bt ≈ exp − r(t|sk )∆sk k=1 n r(t|t) = exp − r(t|s)ds r(t|t) t T (7. Again. to remind you. (7.14): n B(t|T ) = exp − This gives n r(t|sk )∆sk k=1 . APPLICATION OF THE FACTOR FORM:INTEREST RATE AND CREDIT DERIVATIVES the discretization of (7. T dB(t|T ) = B(t|T )r(t|t) − B(t|T ) − B(t|T ) t T 1 µ(t|s)ds + B(t|T ) 2 σ(t|s)ds dz. t (7. In fact. the point of this is that now we can calibrate from forward rate market date r(t|s) rather than having to go through bond prices B(t|T ). (7. Thus.17) Br(t|si ) ≈ − exp − Br(t|si )r(t|sj ) ≈ exp − r(t|sk )∆sk k=1 ∆si = − exp − ∆si ∆sj = exp − r(t|s)ds ∆si t T (7.22) which makes the relationship a little more explicit.18) n r(t|sk )∆sk k=1 r(t|s)ds ∆si ∆sj . T t t T σ(t|s)σ(t|r)drds dt t Now.19) Plugging these into Ito’s lemma gives n n n dB(t|T ) = exp − r(t|sk )∆sk k=1 n n r(t|t) − i=1 µ(t|si ) exp − n r(t|sk )∆sk k=1 ∆si 1 + 2 − Taking continuous limits yields i=1 j=1 n i=1 σ(t|si )σ(t|sj ) exp − n r(t|sk )∆sk k=1 ∆si ∆sj  dt  σ(t|si ) exp − r(t|sk )∆sk k=1 ∆si dz.21) The upshot of this calculation is that the mean and the volatilities of the forward rates r(t|s) must be related through this equation.68CHAPTER 7. applying the Price APT equation leads to T r(t|t) − or µ(t|s)ds + t 1 2 1 2 T t t T T σ(t|s)σ(t|r)drds = r(t|t) − T T σ(t|s)ds λ1 t (7.20) T t T t t µ(t|s)ds − σ(t|s)σ(t|r)drds = t σ(t|s)ds λ1 . we have ”pulled back” the Price APT relationship onto the underlying factors. .

T2 )) (7. . etc. we will model the forward rates as stochastic differential equations.. 7. T2 )dz2 For notational simplicity. Thus. n. using the factor approach and pdes is not easy. . INTEREST RATE DERIVATIVES 69 This is just the calibration phase. Nevertheless. we use a geometric Brownian motion model. For simplicity. Ti )) (7.2.25) B(t|T1 ) (1 + τ R(t|T1 . the idea is that this can make calibration easier.27) (7. this is also a model that is easier to price with using the risk neutral approach.4 The LIBOR Market Model This model is similar to the HJM model except that it uses discrete forward rates instead of instantaneous forward rates. This is one case in which risk neutral pricing (Chapter 9) can help quite a bit. Let R(t|T1 . To price some derivative we would not have an explicit relationship between the derivative and the underlying variables r(t|s).. For simplicity.. T2 ) be the forward interest rate between time T1 and T2 as seen at time t. the factor approach can provide us with an important perspective on this model.30) . let’s write Ri = R(t|Ti . The point is that for actual pricing of a new derivative.2. (7. (7. zi−2 . Due to its similarity with HJM..26) Now. For further reading on this approach see [3].24) etc for i = 1. but also Bi−1 .. zi−3 ...7. dR(t|T1 . we will be able to use an explicit relationship between the marketed tradables of bonds and the underlying variables of discrete forward rates to pull the Price APT relationship onto the underlying variables. it should be clear that Bi depends on Ri−1 and hence the factor zi−1 . Now. T2 )dt + b1 R(t|T1 . z1 .28) (7. Furthermore. T2 ) = a1 R(t|T1 . Now since Bi−1 depends on Ri−2 and Bi−2 . let us write generically that i−1 dBi = µi Bi dt + Bi j=1 σij dzj . then Bi ultimately depends on the factors zi−1 . Once again. Ti+1 ) and Bi = B(t|Ti ) so that dRi = ai Ri dt + bi Ri dzi Then prices of tradables satisfy Bi = Bi−1 1 + τ Ri−1 (7. let Ti+1 = Ti + τ where τ is a fixed amount of time.29) The relationship above leads to a recursive dependence Bi = (1 + τ Ri )Bi+1 .23) B(t|T1 ) = (1 + τ R(t|T1 )) and for bond prices and forward rates we have B(t|T2 ) = and more generally B(t|Ti ) = B(t|Ti−1 ) (1 + τ R(t|Ti−1 . and thus Ito’s lemma (to create the tradables table) combined with the Price APT would lead to an infinite dimensional pde. Again. we use an interest rate convention so that the price of a zero coupon bond is 1 (7.

j dzj  (7.32) (7. This allows us to solve for σi+1. the tradables look like   i dBi = τ Bi+1 (ai Ri ) + τ bi Ri Bi+1 j=1 +τ Bi+1 bi Ri dzi + (1 + τ Ri ) Bi+1 = Bi µi+1 +  i−1 j=1  σi+1.38) we obtain σi+1. First. equating the coefficients of zj for j < i in (7.34). by combining (7. Now.j dzj  . (1 + τ Ri ) (7.34) gives (1 + τ Ri )Bi+1 σi+1.  (7. From this we can get two things.i as σi+1.j ρij  dt  σi+1. Since the coefficient of zi in (7.33)  τ Bi+1 (ai Ri ) + τ bi Ri Bi+1 This is the expression for our tradables.70CHAPTER 7. (1 + τ Rj ) (7.i = − τ bi R i . APPLICATION OF THE FACTOR FORM:INTEREST RATE AND CREDIT DERIVATIVES Using Ito’s lemma gives dBi = = τ dRi Bi+1 + (1 + τ Ri )dBi+1 + τ dRi dBi+1  +τ bi Ri Bi+1   i (7.j = σi.29) is zero.39) (7.j ρij σi+1.j dzj   (7.j .38) (7.29) we should have that τ Bi+1 bi Ri + (1 + τ Ri )Bi+1 σi+1.i = 0.j . noting that Bi = (1 + τ Ri )Bi+1 gives σi+1. we note that by comparing this to (7.36) and (7.40) 1 + τ Ri +Bi  σi+1.31) i j=1 τ Bi+1 (ai Ri dt + bi Ri dzi ) + (1 + τ Ri ) µi+1 Bi+1 dt + Bi+1 j=1 i j=1 =  σi+1.j ρij + (1 + τ Ri )(µi+1 Bi+1 ) dt i j=1 τ a i R i + τ bi R i  i j=1 σi+1.j ρij + (1 + τ Ri )(µi+1 Bi+1 ) dt i j=1 σi+1. we can move to constructing the tradables table and applying the Price APT. Returning to (7.41) .j = Bi σi.35) +τ Bi+1 bi Ri dzi + (1 + τ Ri ) Bi+1  σi+1.37) Once we have established these relationships. i > j.j = − τ bj R j . Thus.j dzj  dt  (7.29) and (7.36) (7.34) Futhermore.

39) was used in the last equality.7.j terms. there are only n − 1 market prices of risk. (Note that with n tradables as bond prices.43). the discrete analog to the continuous equation used in HJM T B(t|T ) = exp − r(t|s)ds t (7. giving   i i−2 i−1 τ ai Ri + τ bi Ri j=1 σi+1. there are a couple of difference that are helpful to point out.44) λj σi. highly related to the HJM model.j terms. of course. we only have n − 1 factors zi .j + λj σi+1. But.39) to get rid of those terms and have   τ bj R i i−2 i−1 τ ai Ri − τ bi Ri j=1 (1+τ Rjj ) ρij τ bj R j τ bj R j  λj = − + (7.49) .j ρij  (7. we used a recursive relationship to relate the underlying variables to the marketed tradables Bi = (1 + τ Ri ) which can be expanded to give Bi = (1 + τ Ri ) Bi−1 1 = (1 + τ Ri−1 ) j=0 (1 + τ Ri−1 ) i−1 Bi−1 (1 + τ Ri−1 ) (7.j (7.43) These equations mix parameters from the underlying variables (ai and bi ).j =  1 + τ Ri j=1 j=1 This still contains σi.47) (7. µi = µi+1 + τ a i R i + τ bi R i i j=1 σi+1.42) into (7.2. each discrete forward rate is driven by a distinct factor dzi . The next thing to note is that in the Libor Market Model. let’s substitute (7. in fact.48) This is. Thus. INTEREST RATE DERIVATIVES where (7. and from (7. In the Libor Market Model.42) where r0 is the short rate process. The first is that we derived that HJM as a single factor model (a multifactor model is easy to do as well). Thus.41).j ρij 1 + τ Ri (7.j ).45) λj − (1 + τ Rj ) (1 + τ Rj ) 1 + τ Ri j=1 j=1 −λi−1 τ bi−1 Ri−1 (1 + τ Ri−1 ) =  τ a i R i − τ bi R i i j=1 τ bj Rj (1+τ Rj ) or ρij 1 + τ Ri   (7. We want conditions that don’t involve anything related to the marketed tradables. all the instantaneous forward rates were driven by the same factor dz.46) which is the calibration relationship pulled onto the underlying variables of the discrete forward rates Ri . and the marketed tradables (µi and σi.) Relations to HJM The Libor Market Model is. However. The Price APT then tells us that µi = r0 + j=1 71 i−1 λj σi+1. we would like to eliminate µi and σi. To do this. and that is why the above market price of risk is λi−1 and not λi . That is. we can substitute in using (7.

1. and then we will generalize that to allow the intesity to be random. (7.. and the second is a default factor. I hope you have found this exercise valuable.. In fact.55) From the first equation we have λ0 = r0 the short rate. N .72CHAPTER 7. we can start it at N = 0 which is the no default state. 2 (7. In what follows. Section 6. You should note the similarity between these models and Merton’s jump diffusion model in Chapter 6.50) (7. let’s move on to credit. The first is the short rate. However. We model these as dr0 dN = = adt + bdz dπ(α) (7. the two models (HJM and Libor Market Model) really are brothers.58) (7. By Ito’s lemma we can write.57) 2 But.. so we have 1 Bt (0) + (a − λ1 b)Br (0) + b2 Brr (0) = (r0 + α − λ2 )B(0) + (λ2 − α)B(1).3.6. The second equation gives r0 B(N ) + bBr (N )λ1 + (B(N + 1) − B(N ))λ2 = LB(N ) which can be rewritten as 1 Bt (N ) + aBr (N ) + b2 Brr + α(B(N ) − B(N + 1)) = r0 B(N ) + λ1 bBr (N ) + λ2 (B(N + 1) − B(N )). This is typically not done because the risk neutral framework turns out to be better suited for these models.51) In this case. which includes the money market account: B0 B(N ) d B0 B(N ) = r0 B0 LB(N ) 0 bBr (N ) dt + 0 bBr (N ) 0 (B(N + 1) − B(N )) λ1 λ2 dz dπ − αdt (7. the most important thing to note about the HJM and Libor Market Model is that they can both be viewed and understood from the factor point of view.52) Finally. t|T ). despite their looking quite complicated. we need two factors. we solve the Price APT equations B0 B(N ) λ0 + 0 (B(N + 1) − B(N )) = r0 B0 LB(N ) (7.1 Defaultable Bonds In deriving equations for defaultable bonds. I will present the simplest models of a Defaultable Bond when the intensity of default is a constant. APPLICATION OF THE FACTOR FORM:INTEREST RATE AND CREDIT DERIVATIVES Thus.53) (7. N. it is important to understand that these models all come from just a simple application of the factor approach. and let N = 1 be the default state. and t: B(r0 .54) (7. credit model rely heavily on Poisson processes. we assume that we start with N = 0 and default is N = 1. Since a bankruptcy is a sudden event.. Finally. a defaultable bond of maturity T is a function or r0 . after suppressing all arguments except N : dB(N ) = LB(N )dt + bBr (N )dz + (B(N + 1) − B(N ))(dπ(α) − αdt) where I have compensated the Poisson process and 1 LB(N ) = (Bt (N ) + aBr (N ) + b2 Brr (N ) + α(B(N ) − B(N + 1))) 2 Now let’s write down the tradables table. Since N (t) is a pure Poisson process. 7. if you understand Merton’s model then there isn’t too much new here. 7.3 Credit Derivatives Credit derivatives usually refer to derivatives that pay off depending on whether a bankruptcy has occured.56) .

Again.65) Finally.62) This time we will allow the default intensity to follow a stochastic differential equation. we assume that we start with N = 0 and default is N = 1. or fractional recovery B(1) = xB(0). we can assume different recoveries in default such as no recovery B(1) = 0.61) (7. so we have 1 1 Bt (0)+(a−λ1 b)Br (0)+(f −λ2 g)Bα (0)+ b2 Brr (0)+ g 2 Bαα (0)+ρgbBrα (0) = (r0 +α−λ3 )B(0)+(λ3 −α)B(1). By Ito’s lemma we can write: dB(N ) = LB(N )dt + bBr (N )dz1 + gBα (N )dz2 + (B(N + 1) − B(N ))(dπ(α) − αdt) (7. since B(0) is the no default state. Furthermore. and let N = 1 be the default state. then there will also be a closed form solution for defaultable bonds! 7. In this case. α and t: B(r0 . .66) λ0 + LB(N ) bBr (N ) gBα (N ) (B(N + 1) − B(N )) B(N ) λ3 From the first equation we have λ0 = r0 the short rate.3. the price is the same. we solve the Price APT equations   λ1 r0 B0 0 0 0 B0  λ2  = (7. N. α. N .59) 2 This looks exactly like the standard model for a bond. That is. If we assume no recovery we obtain 1 Bt (0) + (a − λ1 b)Br (0) + b2 Brr (0) = (r0 + α − λ2 )B(0) (7. we have where E[dz1 dz2 ] = ρdt.63) where again I have compensated the Poisson process and this time 1 1 LB(N ) = (Bt (N )+aBr (N )+f Bα (N )+ b2 Brr (N )+ g 2 Bαα (N )+ρbgBrα (N )+α(B(N )−B(N +1))) (7. Furthermore. or even fixed recovery B(1) = X. we can assume different recoveries in default such as no recovery B(1) = 0. 2 2 (7. That is.68) But. B(1) means that we are in default. a defaultable bond of maturity T is a function of r0 . Hence. Otherwise. it is the same as B. except that the short rate is increased by α − λ2 . or fractional recovery B(1) = xB(0). This means that if there is a closed form solution for bond prices under a single factor short rate model. t|T ). (7. or even fixed recovery B(1) = X.7. since B(0) is the no default state.60) (7. Hence.3. The second equation gives r0 B(N ) + bBr (N )λ1 + gBα (N )λ2 + (B(N + 1) − B(N ))λ3 = LB(N ) which can be rewritten as 1 1 Bt (N ) + aBr (N ) + f Bα (N ) + 2 b2 Brr (N ) + 2 g 2 Bαα (N ) + ρgbBrα (N ) + α(B(N ) − B(N + 1)) = r0 B(N ) + λ1 bBr (N ) + λ2 gBα (N ) + λ3 (B(N + 1) − B(N )). it is the same as B(0).67) But. B(1) means that we are in default.2 Defaultable Bonds with Random Intensity of Default dr0 dN dα = = = adt + bdz1 dπ(α) f dt + gdz2 (7. the default rate and its market price of risk just adjust the short rate of interest. CREDIT DERIVATIVES Different Types of Recovery 73 But.64) 2 2 Now let’s write down the tradables table:   dz1 0 0 0 r0 B0 B0 B0   dz2 dt + = d bBr (N ) gBα (N ) (B(N + 1) − B(N )) LB(N ) B(N ) B(N ) dπ − αdt (7. we start with N = 0 which is the no default state.

where the short rate process is being driven by zB . t) must satisfy. Additionally. Assume that this stock also pays a continuous dividend at a rate of q. However. t).74) . If no arbitrage exists in the market. Thus. the dividend amount is qSdt. respectively. (7. That is: dS dr0 = = µSdt + σSdz1 √ (7. assume that interest rates are random. Problem 7. Your answer may contain a market price of risk. Hint 2: Note that a forward price is not tradable.4. but moves up and down randomly. Hint 3: My recommendation is to let your underlying variables be the future and forward price. Derive the pde for a derivative on a futures contract and on a forward contract.4.69) (7. Assume that a money market account exists that satisfies dB0 = r0 B0 dt. you may assume that the asset that the forward contract is on is tradable on a spot market and there are standard relationships between the spot price of an asset and its forward price. and the short rate. Hint 1: Recall that futures prices are marked to market (See Section 6. r0 (t). r0 (t). whereas forward prices are not marked to market.4.73) Consider a third asset whose price at time t can be written as a twice differentiable function of S(t). That is.4 (Flat Term Structure) Consider a term structure model where the term structure of interest rates is flat. derive the pde that c(S(t). and the short rate follows Cox-Ingersoll-Ross dynamics. Additionally.71) where z1 (t) is a standard Brownian motion.74CHAPTER 7. r0 (t) and t.1 Derive a pde for the price of a European call option on a non-dividend paying stock when interest rates are random.4 Problems Problem 7. (Your answer may contain a market price of risk. it might be convenient to write bond dynamics generically as dB = µB Bdt + σB BdzB . over time dt.) Problem 7. let zero coupon bond prices with face value $1 and maturity T be denoted by B(t|T ) and satisfy B(t|T ) = exp(−r(T − t)) (7. Call this price function c(S(t).1. (b) What if interest rates are not stochastic? Do the pdes for options on forwards and futures look the same? Problem 7.70) a(b − r0 )dt + c r0 dz2 where dz1 and dz2 are correlated E[dz1 dz2 ] = ρdt.5 in Chapter 6. and the term structure is driven by a single factor short rate model dr0 = a(b − r0 )dt + f dz2 (7.2 (Options on Forwards and Futures) (a) Assume interest rates are stochastic and driven by a single factor short rate model.72) where z2 (t) is a standard Brownian motion and E[dz1 dz2 ] = ρdt.4. APPLICATION OF THE FACTOR FORM:INTEREST RATE AND CREDIT DERIVATIVES 7.3 (PDE for a derivative on a dividend paying stock under stochastic interest rates) Consider a market with a stock price process S(t) satisfying dS = µSdt + σSdz1 (7. Assume the following df dr0 = = µf dt + σf dz adt + bdzB where f is either the forward price or futures price and E[dzdzB ] = ρdt.

t) and b(r. t)dt + b(r. Note that this model applies for all maturities T . t)dz.7. 75 (7. (b) Derive the absence of arbitrage condition in this case. PROBLEMS where r is modeled as a stochastic differential equation dr = a(r. for B(t|T )).75) (a) Write down models for the instantaneous return of the money market account and for a generic zero coupon bond with maturity T (i.4. and derive restrictions on a(r. t).e. What does this imply about the allowable dynamics for this term structure? .

76CHAPTER 7. APPLICATION OF THE FACTOR FORM:INTEREST RATE AND CREDIT DERIVATIVES .

we actually just mean that we will form a portfolio (that may be dynamically traded over time) so that the factor model of the portfolio eliminates all factor risk.2 Hedging from a Factor Perspective In abstract terms.Chapter 8 Hedging 8. We are then hedged against variations in these underlying variables if the derivative of the value of a portfolio with respect to the underlying variables is zero. we recognize that risk comes from the factors. we will work with prices. Let us consider having various tradable assets to hedge with.2) dVh = Ah dt + Bh dz Now. our portfolio is not sensitive to small variations in the underlying variables.3) To eliminate the risk. we consider a derivative to be a function of underlying variables. In this case. we need to eliminate the coefficients of the factors. we will assume that we hold one unit of this asset. hedging involves eliminating factor risk. we have entirely hedged out the risk. 8. Let dVu be the value change of the asset that we would like to hedge. hedging is based upon eliminating factor risk. we need to choose y such ˆ that Bu + y T B = 0 ˆ (8. we can either work with returns or prices. By hedging. Once again.1) and we would like to hedge this position. Furthermore. This change in value is given by dV0 = dVu + y T dVh = (Au + y T Ah )dt + (Bu + y T Bh )dz ˆ ˆ ˆ (8. and assume that these assets have a value profit/loss change vector of (8. let y be the holdings of the assets used to hedge with and let dV0 be the value change of the hedged ˆ portfolio.1 Introduction We present two main approaches to hedging. Thus. Thus. In the first. Thus. In the second approach. In this chapter. Thus a factor model for our unhedged portfolio profit/loss over the next time instance is dVu = Au dt + Bu dz (8.4) That is really all there is to hedging! 77 .

6) 8.10) (8. but add our holdings variable y Holdings y Prices P Changes d V = Factor Model A dt + B dz (8. a hedged portfolio will automatically satisfy this condition. lets assume that there is a tradable with no direct factor risk dB0 = r0 B0 dt (8.78 CHAPTER 8. . Consider a tradables table description. a standard derivation of the Black-Scholes equation begins from a hedging argument.8) Note that y T B = 0 is one of the conditions of the arbitrage price implication. y T P = 0. Hence.2. y is the holdings of the assets with value changes of dVh .6)). we select y so that y T B = 0 (recalling of course that y is given by (8. the asset to be hedged satisfies dVu = Au dt + Bu dz and the tradables used to hedge this asset are dVh = Ah dt + Bh dz We can write this in a tradables table form as           0 r0 B0 y0 B0 B0  y   Ph  ˆ d  Vh  =  Ah  dt +  Bh  dz. HEDGING 8. First.11) (8. from the line following equation (8. ˆ Creating a No Cost Hedge Let’s break out the tradables table in a little more detail.2. The other condition that needs to be satisfied to set up the arbitrage is that the total cost or price must be zero. ˆ (8.7) y ˆ 1 (8. our holdings vector is actually y= and the value change in the hedged portfolio is dV0 = y T dV = y T Adt + y T Bdz Thus. Recall the arbitrage price implication y T P = 0 No cost y T B = 0 No risk ⇒ y T A = 0 No return (8.7). using the notation above. In fact. so let’s rework the hedging analysis. let’s see how hedging and arbitrage are related. and we hold a single ˆ unit of the asset to be hedged.2 The Relationship Between Hedging and Arbitrage Hedging is actually quite closely related to arbitrage. Thus. Bu Au Vu 1 Pu (8. to hedge.12) where y0 is the holding of B0 . In this section.5) Let us assume that the last tradable is the derivative that we would like to hedge and we assume that we hold one unit of that derivative.9) Additionally. Let’s see how we can alter our hedged portfolio to satisfy this no cost condition.1 Description Using a Tradables Table I like to use a tradables table description.

That is. That is really all that we are doing with the above arguments! 8. ˆ           r0 B0 0 B0 0 B0  dt +  σS  dz. In an interest rate derivative setting.1 we have the following tradables table with the first column being the holdings. Thus. HEDGING FROM A FACTOR PERSPECTIVE 79 Now. the hedged portfolio has no direct ˆ factor risk. we make the following important observation. this portfolio is hedged if y T B = 0 which in this case is y σS + σScS = 0 ˆ (8.2. First. any completely hedged portfolio can be altered to satisfy the price APT implication. let y be the holdings of ˆ a hedged portfolio.2. we assume the holding of the stock is y . Thus. Thus.14) This profit/loss condition is actually the Black-Scholes equation! Thus. we can choose its holding y0 arbitrarily without affecting the hedge. Thus. This means y0 rB0 + y T Ah + Au = 0 ˆ (8. and all we are saying is the the hedged portfolio must earn the risk free rate. The holding in the first asset y0 has no effect on the hedge! Since it has no factor risk. including it in a portfolio has no effect on the factors! Hence.3 Hedging Examples Let’s see how hedging is done in some examples. Pricing The above portfolio is hedged.8.1. The quantity cS is typically called the delta of the option. we use y to hedge away all the factor risk in our portfolio. the tradable without direct factor risk is the money-market account and we are saying that the hedged portfolio must earn the short rate. we must have zero profit/loss in this hedged portfolio. but we can convert it to satisfy the arbitrage implication by choosing y0 so that the total cost is zero y0 B 0 − c S S + c = 0 (8.17) . Section 6. We have assumed that we have one option c and that we are hedging with the stock S. we have a hedged portfolio if we hold −cS shares of the stock for every ˆ ˆ option. Since it has no factor risk. a hedging strategy can be used to derive the Black-Scholes equation via the above relationships. We hold an asset that we would like to hedge. This recognition allows us to select y0 so that the hedge has zero cost.15) d S  =  1 2 2 σScS c c 1 ct + µScS + 2 σ S cSS Now. In the Black-Scholes setting. for no arbitrage to exist.16) Solving for y gives y = −cS . A Simple Explanation Here is the simple explanation of what we have done above. and then select y0 so that the total cost is zero y 0 B 0 + y T P h + Pu = 0 ˆ (8.13) Thus. for no arbitrage to exist it must be the same as the first tradable that also has no factor risk. this first asset is the risk free asset. Hedging in Black-Scholes In the Black-Scholes set-up of Chapter 6.  y   S  µS ˆ (8.

we choose y0 so that the total cost is zero y0 B 0 − 2 Br (T0 ) 1 B (T ) + B 2 (T0 ) = 0 1 Br (T ) (8.24) gives 2 B 2 (T0 ) 1 1 1 Br (T0 ) 1 1 1 2 2 2 B (T ) − B 2 (T0 ) − r1 (B (T )+aBr (T )+ b2 Brr (T ))+(Bt (T0 )+aBr (T0 )+ b2 Brr (T0 )) = 0 1 Br (T ) Br (T ) t 2 2 (8.18) which is the Black-Scholes equation. ˆ ˆ Pricing Using the same procedure as in the Black-Scholes case. However.1.20) (8.18) for y0 B0 = cS S − c from (8. the intuition is important as well! Hedging in Bond Pricing Consider the single factor short rate models of Chapter 7.21) Now. I presented the more structured derivation because I believe that it is always important to have structure to fall back on when your intuition fails.19) (8. we must have no profit/loss y0 r0 B0 − Using y0 B0 = r0 2 1 1 Br (T0 ) 1 1 1 2 2 2 (Bt (T ) + aBr (T ) + b2 Brr (T )) + (Bt (T0 ) + aBr (T0 ) + b2 Brr (T0 )) = 0 1 (T ) Br 2 2 (8. Once again. For no arbitrage to be present. HEDGING This is now a potential arbitrage portfolio. this portfolio is hedged if y T B = 0 which in this case is 2 y bBr (T ) + bBr (T0 ) = 0 ˆ 1 B 2 (T ) r (8.80 CHAPTER 8.2.23) and substituting this into the first term in (8. we must have no profit/loss which means that the drift term of our portfolio must be zero 1 y0 r0 B0 − cs µS + (ct + µScS + σ 2 S 2 cSS ) = 0 2 Substituting in (8. Following this model. Section 7.17) gives 1 r0 (cS S − c) − cs µS + (ct + µScS + σ 2 S 2 cSS ) = 0 2 or 1 ct + r0 ScS + σ 2 S 2 cSS = r0 c 2 (8. we can convert this hedged portfolio into a potential arbitrage portfolio and derive a pricing equation.26) . Again. Note that hedged portfolios of bonds are sometimes called ”immunized”.24) 2 Br (T0 ) 1 1 Br (T ) B (T ) − B 2 (T0 ) from (8.25) which can be rewritten as 1 2 2 1 2 1 Bt (T0 ) + aBr (T0 ) + 2 b2 Brr (T0 ) − r0 B 2 (T0 ) B 1 (T ) + aBr (T ) + 1 b2 Brr (T ) − r0 B 1 (T ) 2 = t 2 (T ) 1 (T ) Br 0 Br (8.22) Solving for y gives y = − Br1 (T0) . the simpler explanation of this derivation is that the hedged portfolio is risk free and hence must earn the risk free rate.23) and note that for no arbitrage to exist. let’s write down the tradable table with holdings:           r0 B0 0 0 B0 B0 1 1 1 1  y   B 1 (T )  ˆ d  B 1 (T )  =  (Bt (T ) + aBr (T ) + 1 b2 Brr (T ))  dt +  bBr (T )  dz 2 1 2 2 2 2 2 2 2 bBr (T0 ) 1 B (T0 ) B (T0 ) (Bt (T0 ) + aBr (T0 ) + 2 b Brr (T0 )) (8.

which is the money market account. we will have choices in terms of how we want to best try to reduce risk from the factors.1. Since the bond B is not driven by any of the risky factors. and that I will hedge with the stock S. To see how this is done.2.1. ˆ Since this hedged portfolio has no factor risk. let’s let λ′ = λb (8. To make this look like our previously derived bond pricing equation in Chapter 7 Section 7.32) − − (c(Y S ) − c(S ))dπ − αE[(c(Y S ) − c(S ))]dt (8.2. let’s consider an example.33) I have added the vector of holdings on the left side of the tradables table. The intuitive explanation of this derivation is that first we hedge out the factor risk by the choice of y . But.36) One can clearly see that it is not possible to eliminate all the factor risk by choosing y. we may still attempt to reduce the effect of the factors on our portfolio. the hedged portfolio takes the form dVh = = = ydS + dc y((µ + αE[Y − 1])Sdt + σSdz + Sdψ1 ) + Lcdt + ScS dz + dψ2 [y(µ + αE[Y − 1])S + Lc]dt + [yσS + ScS ]dz + ySdψ1 + dψ2 (8.30) which is the bond pricing equation where λ is the market price of risk.4 Hedging under Incompleteness In some cases it is impossible to eliminate all of the factor risk (this is true in incomplete markets). Thus. . In the jump diffusion model of Chapter 6 Section 6.27) can be written as 1 1 1 1 Bt (T ) + aBr (T ) + 2 b2 Brr (T ) − r0 B 1 (T ) = λb 1 (T ) Br (8.31) d  S  =  (µ + αE[Y − 1])S  dt +  σS 1 σScS 0 1 Lc c c dψ2 where L is the differential operator corresponding to the drift term in Ito’s lemma. I do not need to consider it in the hedge. and dψ1 dψ2 = = (Y − 1)dπ(α) − αE[Y − 1]dt − − (8. So.27) for some constant λ′ .8.28) so that (8. since the left hand side only depends on B 2 and the right hand side only depends on B 1 and B 1 was a bond of arbitrary maturity T . I have assumed that I hold 1 unit of the derivative c.29) Upon rearranging we have 1 1 1 1 Bt (T ) + (a − λb)Br (T ) + b2 Brr (T ) = r0 B 1 (T ) 2 (8. we must have that 1 1 1 Bt (T ) + aBr (T ) + 1 b2 Brr (T ) − r0 B 1 (T ) 2 = λ′ 1 Br (T ) (8.35) (8.            0 0 0 0 r0 B B B dz  y   S  S 0   dψ1  (8.6. In this case. HEDGING FROM A FACTOR PERSPECTIVE 81 Now. we had the following tradables table.2.34) (8. we are in an incomplete market. This is where the pricing pde comes from! 8. it must earn the same return as the tradable with no factor risk.

we cannot eliminate all the risk. Let’s consider a stochastic volatility model: dB dS dv with the tradables table   B  S  c  √ = µSdt + vSdz1 = adt + bdz2 = r0 Bdt (8. (8. In fact. But. this is not consistent because to derive the Black-Scholes formula we assume that volatility is not stochastic.43) (8. Let’s consider a simple hedge where we only eliminate the √ √ dz1 risk.39) (8. Consider the following example.5 A Question of Consistency Note that the hedges we have derived above often involve knowledge of a pricing formula for the option c.44) (8. λE[B 2 ] + σ 2 S 2 (8. t) and computing cS from that? But. we are assuming that volatility is stochastic and thus there is no reason to believe that c would follow the Black-Scholes equation.38) where A = B = Minimizing over y gives y= and sending dt → 0 leads to y= c(Y S(t− ). That is V ar(dVh ) 2 = E[A2 ] − 2yE[AB] + y 2 E[B 2 ] λdt + V ar(A) − 2yCov(A. so we cannot perfectly hedge away the risk. Thus. B) + σ 2 S 2 cS λE[B 2 ] + λ2 dtV ar(B) + σ 2 S 2 λE[AB] + σ 2 S 2 cS .47) 2 2 Clearly.37) where cS is the partial derivative of Merton’s pricing formula. (8.40) λE[AB] + λ2 dtCov(A. In our setting above. t− ) B(Y − 1)S. Thus. This presupposition of knowledge can bring up a question of consistency between the hedge and the assumption of the formula for c.82 CHAPTER 8. This is where the inconsistency in hedging often arises. we would choose y = −cS (8. our hedging analysis has presupposed that the derivative c follows a specified formula that we know. let’s consider a different alternative. Thus.2. 2 Now.46) dz2 Lc c vScS bcv √ 1 with Lc = ct + µScS + acv + 2 vS 2 cSS + 1 b2 cSS + ρ vbScSv .45)      0 r0 B B √0 dz1 0  d  S  =  µS  dt +  √ vS . what is cS ? Well. Nevertheless.41) (8. HEDGING However. we can select y to eliminate some of the risk over the next dt. we choose y vS + vScS = 0 or y = −cS . this is an incomplete market. what Merton [11] did in his pricing formula is equivalent to eliminating the Brownian risk dz. let’s consider a hedged portfolio √ √ √ 1 1 dVh = y(µSdt + vSdz1 ) + (ct + µScS + acv + vS 2 cSS + b2 cvv + ρ vbScSv )dt + vScS dz1 + bcv dz2 (8. . B) + y 2 V ar(B) λ2 dt2 + [σScS − yσS] dt (8. This can be seen by noting that y is often a function of cS for instance. how about using the Black-Scholes formula for c(S. t) − c(S(t− ). our hedge is to hold −cS shares of the stock. with y. Let’s choose y to eliminate the variance of the portfolio over the next dt. But.42) 8. In that case.

HEDGING FROM AN UNDERLYING VARIABLE SENSITIVITY PERSPECTIVE What formula for c? 83 So. The pricing formula c that I should be using is the one that best reflects the actual movement of c in the market. If there is no hedging justification for a pricing formula.3. ease of use. As we saw above.8. Due to standard finance conventions. For example. and hedge against those variables by eliminating the sensitivity to those underlying variables. t) + y S ˆ (8. we note that all the risk in the price of an option comes from its dependence on the stock variable. we will be hedged if our portfolio has no sensitivity to changes in the stock. if there is stochastic volatility. However. If I were interested in using some trading strategy that depended on volatility v but not the stock price S. In practice. Thus. Any pricing formula should be related to a reasonable hedging scheme via our analysis above. then this would be perfectly reasonable. Why? Because hedging is the mechanism that enforces pricing. Not every hedging strategy should be turned into a pricing formula. so keep a sharp eye out for where it may be occurring. This pricing formula should be the best pricing formula that reflects the actual pricing and movement of the derivative c in the actual market. you ask. some might argue that you should use a pricing formula that comes from the hedge that you are doing. Another way of saying this is that we want the derivative of Ph with respect to S to be zero. you want to hedge for a reason unrelated to pricing. Sometimes. Thus. the reverse is not true.3 Hedging from an Underlying Variable Sensitivity Perspective In some cases. Let’s see why. Here is the wrong part. every pricing formula should be intimately connected to a hedging strategy. including computational. To summarize. in this case. many times that is not done (for many reasons. In the simplest terms. then there is no good reason to expect that pricing formula to hold. That means that small changes in S will cause no change in the value of the hedged portfolio Ph . Here is the correct part. In this approach. in the stochastic volatility case I might just want to hedge out the stock risk S via dz1 and leave my portfolio exposed to volatility risk. However. That is. sensitivity is measured by the derivative of the hedged portfolio with respect to the underlying variable of concern. Furthermore. Now if we would like to hedge out the risk in our option. since all the risk comes from the ˆ stock variable. then deviations from that pricing strategy can be exploited by turning the hedging strategy into an arbitrage (or almost arbitrage) opportunity as shown in the previous section. we form a hedged portfolio Ph = c(S. 8. Now. The answer is that you should use the formula that best corresponds to the actual price and movements of c in the market. there is a simpler and faster way to derive hedges that doesn’t involve an explicit use of the factors. But it probably would not be reasonable to claim that I should be using a pricing formula related to this hedging strategy. But. then what formula should I use for c. if a pricing formula is tightly related to a hedging strategy. we assume that an option is a function of the underlying stock S and time t. then you should use a model that most accurately captures that stochastic volatility and how it is reflected in the movement of the derivative c. 8.1 Black-Scholes Hedging For example. . often hedging analysis is inconsistent. Hence. people like to rely on the Black-Scholes formula even when its assumptions are not valid. we will be hedged. This idea is both right and wrong. Thus.48) and want to choose y so that this portfolio is hedged. in places below we will fall into this trap as well. pricing and hedging are intimately related. t). hedging strategies often rely on a pricing formula for the derivative c.3. etc). in the Black-Scholes setup. the price of an option is a function of the variables S and t which we write as c(S. For example. we consider the asset that we are trying to hedge to be a function of underlying variables.

this means that the value of the portfolio change is approximately zero for small changes in the price of the stock. Right . t|T0 ) that is a function of the short rate r0 (t) and time t. and delta hedged portfolio for an option with strike K = 10 and expiration T = 0. Thus. Figure 8. Middle . Recall that the derivative is the change in a function for a small change in the variable. In that case. a portfolio Ph = B 2 (r0 . ˆ ˆ r (8. let’s assume the option is a European call option following Black-Scholes. This hedge is known ˆ ˆ as a delta hedge and the quantity cS is commonly referred to as the delta of the option. we hold a bond B 2 (r0 . In this case. the derivative of the portfolio value yS + c is zero (right plot).Plot of the hedged portfolio assuming that the current price of the stock is $10. and the value of the tradable as a function of the underlying factor on the y-axis.Plot of the Stock. In this setup.84 This condition can be written as CHAPTER 8.1 shows a plot of the stock.1: Delta Hedge: Left . The hedged portfolio on the right in Figure 8. For simplicity. the underlying variable is the stock price S and the tradables are the stock itself S and the option c. Thus ˆ ∂Ph 2 = Br (T0 ) + y Br (T ) = 0 ˆ 1 ∂r Solving for y yields y = − Br1 (T0) which is the same answer that we arrived at using factors. But. There is a simple graphical interpretation of this hedge. call option. Consider a plot with the underlying variable on the x-axis.Plot of the option. if the stock price is driven by a . This is the case for stock price movements driven by Brownian motion since Brownian motion is continuous. Thus. Stock Value 15 15 Option Value 15 Hedged Portfolio 10 10 Tradable: Hedged Portfolio 0 5 10 Underlying Variable: S 15 10 Tradable: S 0 Tradable: c 5 5 5 0 0 −5 −5 −5 −10 0 5 10 Underlying Variable: S 15 −10 −10 0 5 10 Underlying Variable: S 15 Figure 8. t|T ) is hedged if its derivative with respect to r0 is zero. this approach only works if we know that the stock price changes will be small. 8.3 and an interest rate of r0 = 0.3.50) B 2 (T ) 8. when we say that a portfolio is hedged against stock price movements because its derivative with respect to the stock is zero.3 on a stock with volatility σ = 0. the risk in the price of a bond comes from the short rate r0 (t) which is our underlying variable. To make this a potential arbitrage portfolio. Hence. We wish to hedge this bond with another bond B 1 (r0 . HEDGING ∂Ph = cS + y = 0 ˆ (8.05.3 Derivatives imply Small Changes Note that this underlying variable approach uses the derivative as a measure of sensitivity. t|T ) that is also a function of the short rate r0 (t) and time t.3.49) ∂S Solving for y yields y = −cS which is the same answer that we arrived at using factors. we could add a position in the bond in order to make the current price of the portfolio (at S = $10) be zero. t|T0 ) + y B 1 (r0 . the value of the portfolio change could be quite large if the stock change is large. However.1 is a portfolio of the stock (left) and call option (middle) so that at the current value of the underlying variable (S = 10).2 Hedging Bonds We can apply this same underlying variables approach to our hedging of bonds.

this Taylor expansion approach assumes that we are not trading continuously. one can also use a higher order approximation to the portfolio value. An easy way to do this is to use the terms of a Taylor expansion. Note that in the typical dynamic hedging assumption. σ) as 1 ∆c(S. Of course. ”theta” starts with ”t” and is the partial with respect to t.. Similarly. we assumed that r0 and σ were constant (not random factors). HIGHER ORDER APPROXIMATIONS 85 Poisson process. only terms of order dt and lower matter. This leads to the so-called Greeks. then you can remember some of the Greeks by noting that the first letter of the Greek is the same as the partial derivative. we are able to trade continuously. higher order terms will enter. From the BlackScholes formula. r0 . 8.51) I only included a single second order term (there are many second order terms) because is it the only named second order term. recognizing that that is only an approximation. ”rho” starts with ”r” and is with respect to r0 . t. Then we can ask how their changes might cause the price of an option to change assuming that the price follows the Black-Scholes formula. By looking at this Taylor expansion. in general. we can allow them to be underlying variables and change. σ) = ct ∆t + cS ∆S + cr ∆r0 + cσ ∆σ + cSS (∆S)2 + . with ”delta” and ”gamma” you are on your own. That is. we would just construct a multivariable Taylor series expansion of c(S. we see that the various derivatives tell us the sensitivity of the price of an option to changes in those variables. presented next. Of course.4 Higher Order Approximations Using the derivative to model the change in a portfolio due to the change in a variable is a linear approximation of portfolio value as a function of the underlying variable.4.2 A Delta-Gamma Hedge One can think of a delta hedge as eliminate the first order term in the Taylor expansion. Each of these derivatives is given a Greek letter name as in Table 8. like I do.8. To do this. This was the situation in the Jump-Diffusion model above. theta delta rho vega gamma ct cS cr cσ cSS Table 8. 2 (8. and ”vega” starts with ”v” and is the partial with respect to ”v”olatility. a call option is not just a function of the price of the stock and time.1: The Greeks If you have a bad memory. However.1. r0 . Thus. and note that the hedging strategy that we derived was not that same one that would result from this derivative approach. then we would expect it to have large jumps at times.4. in this case using the derivative is not a good approach since the stock price change would be large and the derivative would likely not be a good approximation to the change in the portfolio value. we see that it depends also on the risk free rate r0 and the volatility of the option σ. we use a ∆t instead of a dt and furthermore. This is actually more practical than the typical continuous time trading assumptions. Thus. 8. t.1 The Greeks Now. 8. one can go further and ask if higher order terms can be eliminated as well. Thus..4. However. Unfortunately. If you elminate the first order term in . In our derivation of the Black-Scholes formula.

For such a Delta-Gamma hedge you need more than just the underlying stock. t) − cS ∆S 1 ct ∆t + cSS (∆S)2 dt + .61) is also a very useful equation for intuituion.56) (8.55) To Delta-Gamma hedge.4. and furthermore. 1 2 ct + r0 ScS + σi S 2 cSS = r0 c (8. Implied volatility is the value of volatility that when plugged into the Black-Scholes formula will make it equal the current . the hedged portfolio is P = c + y1 S + y2 c(2) (8.1. you need a tradable that depends on the second order term (∆S)2 .52) and let’s Taylor expand this to obtain ∆P (S. t) = = = ∆c(S.62) is that (∆S)2 is σ 2 S 2 dt + higher order terms. Now let’s assume that in the market.86 CHAPTER 8. (8. this would create a portfolio that has the first and second derivative equal to zero at the current value of the underlying variable.57) cSS − cS . we can Delta-Gamma hedge an option c. For the analysis that we are looking at. However. Consider the hedged portfolio P (S. t) + y1 ∆S + y2 ∆c(2) 1 1 (2) (2) (2) ct ∆t + cS ∆S + cSS (∆S)2 + y1 ∆S + y2 ct ∆t + cS ∆S + cSS (∆S)2 2 2 1 (2) 1 (2) (2) ct + y2 ct ∆t + cS + y1 + y2 cS ∆S + cSS + y2 cSS (∆S)2 2 2 (8. Let’s show how by using another call option c(2) and the underlying stock.58) In the plots of Figure 8.61) and (8.59) where I have only kept terms up to order ∆t in (8.53) (8.61) (8... So we will use it as well. the higher order terms don’t matter. Thus. we have to eliminate the coefficients of ∆S and (∆S)2 by choosing y1 and y2 . we must solve c S + y1 + y2 c S 1 (2) 1 cSS + y2 cSS 2 2 The solution is y1 = (2) c (2) S cSS (2) = = 0 0 cSS cSS (2) (8. Delta-Gamma hedges (and other hedges as well) are difficult because transaction costs can make it expensive to trade too many assets. 2 (8.3 Determining what the error looks like We can use the Taylor expansion to see what the error looks like in a Delta hedge under Black-Scholes assumptions.60) (8. c satisfies the Black-Scholes equation corresponding to a volatility value of σi . 2 1 ct ∆t + cSS σ 2 S 2 dt + . HEDGING ∆S and the second order term (∆S)2 than this is called a Delta-Gamma hedge. t) = c(S. 8.62) (8.63) 2 I use the subscript i on the volatility σi to denote what is known as implied volatility. Note that the only difference between (8. t) = = = ∆c(S. t) − cS S and let’s perform a Taylor expansion of this in S and t ∆P (S.. Thus. In practice. In this case.62).. y2 = − (8.54) (8.

T. in hedging we try to eliminate the factor risk. tradables are viewed as functions of underlying variables. σi ) (8.8. Furthermore. and risk free rate is r0 . 8. t) = r0 P dt + cSS 2 2 σ 2 − σi S 2 dt. for this hedge where we are long the option and short delta of the stock. To be more concrete. time to expiration is T . but in terms of the volatility of the stock σ rather than the stock move ∆S. This point of view is appropriate regardless of what the risky factors are. what volatility value are they pluggin in the Black-Scholes formula? Thus.66) shows that the gain or loss of our hedged portfolio relative to the risk free rate depends on the actual change in the stock price over the next ∆t in the term (∆S)2 relative to the implied volatility σi in Black-Scholes that is being used to price the option in the market. Since we only set the derivative to zero.6.61) which gives 1 2 ∆P (S. . SUMMARY 87 market price of an option. r0 .5. K.61). (8. Thus. we can use (8.5 Summary Hedging can be approach from two different points of view. Equation (8. In the second point of view. Usually we do this by setting the derivative of the hedged portfolio with respect to the underlying variable to zero at the current value of the underlying variable. Thus. this works as long as there are only small moves in the underlying variable between rehedging opportunities.6 Problems Problem 8. let cBS (S. In the first point of view.63) to substitute for ct in (8. we can set higher order derivatives of our portfolio to zero as well and create better hedges.65) (8.38). we recognize the fact that risk comes from the factors. σ) denote the Black-Scholes formula. 1 ∆P (S. r0 . Then the implied volatility is defined as the value of σi that solves cm = cBS (S0 .1 Verify equation (8. then you are on your way to understanding the majority of hedging methods. and the derivative reflects a local approximation to the portfolio. In particular.63) assumes that the market is pricing the option using the Black-Scholes formula with a volatility value of σi . we make money if the stock moves more than implied volatility estimate. if you underlying Taylor expansions. Furthermore. t) = r0 (c − cS S)dt + cSS (∆S)2 − σi S 2 dt 2 and finally noting that P = c − cS S gives 1 2 ∆P (S. if we have more tradables to place in our portfolio. and we hedge by constructing a portfolio that eliminates the sensitivity to moves in the underlying variables.67) Equation (8.62) instead of (8. it answers the question: If the market is following Black-Scholes.64) Thus. K.66) (8.67) shows the same thing. T. and we lose money if it moves less. (8. strike price is K. t) = r0 P dt + cSS (∆S)2 − σi S 2 dt 2 or purely to order dt using (8. 8. let cm be the current market price of an option where the stock price is S0 . Really.

88 CHAPTER 8. HEDGING .

Hypothesis: Perhaps by changing the factors from dz to some other random factors dψ. This leads us to ponder the following. especially for those new to derivative pricing. 9. their factor model is determined by the application of Ito’s lemma. you would soon realize that this is not the case. it tends to be one of the most confusing. Ito’s lemma puts a constraint on which factors dψ are consistent with the original factors dz. and B. it is an extremely powerful approach. Why? Because when we deal with derivative securities. A. we have to start with a more basic question. I will explain the risk neutral pricing principle.1 Introduction Risk neutral absence of arbitrage pricing is a widely used approach to derivative pricing. Thus. Therefore. misunderstood. the prices P are absence of arbitrage for any value change with A. This introduction to risk neutral pricing does not follow the standard probability-heavy route. regardless of what the driving factors are. Hence. 89 . I can compute the absence of arbitrage prices P easier.1) and the absence of arbitrage condition is A = Pλ0 + Bλ (9.Chapter 9 The Road to Risk Neutrality 9. Question: Given a set of factors dz. and not on what the exact factors dz are. Nevertheless. However.2) Thus. we have (9. and B.2 Do the Factors Matter? Prices P Changes d V = Factor Model A dt + B dz In our tradables table. absence of arbitrage only depends on the values of P. when understood correctly. Let’s be a little more concrete about this. To see whether something can be made of this hypothesis. you might be tempted to say that I can choose dψ to be anything I want. what other set of factors dψ will have the same A and B representation? At first glance. where the A and B representation of prices changes is the same. Thus. It doesn’t have to relate to the original dz at all because the absence of arbitrage condition ”does not see” dz. and misused pricing approaches. in this chapter. the A and B representation of price changes does see the factors via Ito’s lemma. However. but instead motivates risk neutral pricing in a simple manner from the factor approach.

We can ask whether this z z factor dψ = ηd˜ is consistent with the original dz. I will replace the original Brownian factors by Brownians with a different variance. 2 (9.6) That is.11) (9.7) (9. t) be a derivative security. the new factor should be considered to be the entire term dψ = ηd˜ and not just the d˜.9) And thus we see that dz and dψ = d˜ + βdt are consistent in that they produce the same A and B z representation regardless of whether dz or dψ = d˜ + βdt is the factor! z The upshot is that we can replace any Brownian factors dz by Brownians plus a drift d˜ + βdt. 1 ct + µScS + σ 2 S 2 cSS dt + σScS dz.10) (9.4) (9. Again.2.14) (9. THE ROAD TO RISK NEUTRALITY dS = µSdt + σSdz and let c(S.3) (9.5) 9.90 Let S(t) be a stock price with model CHAPTER 9.1 Brownian Factors Changing the Mean Works Let’s try new factors given by the replacement dz → dψ = d˜ + βdt z (9. and the z same absence of arbitrage prices hold! Changing the Variance Does Not Work Let’s try new factors given by the replacement dz → dψ = ηd˜ z (9. the tradables table is Prices S c Changes d S c = Factor Model µS 1 ct + µScS + 2 σ 2 S 2 cSS dt + σS σScS dz. By Ito’s lemma we have dc = Thus. We would have dS = = = and then by Ito’s lemma we have for c(S. It is important to consider the new factor to be the entire term dψ = d˜ + βdt and not just d˜! z z We can ask whether this will lead to a representation consistent with the original dz.8) (9. t). dc = = = 1 z ct + (µ + σβ)ScS + σ 2 S 2 cSS dt + σScS d˜ 2 1 z ct + µScS + σ 2 S 2 cSS dt + σScS (d˜ + βdt) 2 1 ct + µScS + σ 2 S 2 cSS dt + σScS (dψ) 2 (9.15) .12) µSdt + σS(dψ) µSdt + σS(d˜ + βdt) z (µ + σβS)dt + σSd˜ z (9. We would have z dS = = µSdt + σS (dψ) µdt + σS(ηd˜) z (9. I will replace the original Brownian factors dz by a new factor that is a Brownian d˜ plus a drift z βdt.13) That is.

let’s consider changing the factor to a Poisson with an altered intensity dψ = d˜ (t. Under dπ(t. we see that A is changed when we change the factor to another Brownian with a different variance. then P is also absence of arbitrage if the factors dz are z z z z replaced by dz → dψ = d˜ + βdt with β arbitrary and where d˜ are Brownian factors with E[d˜d˜T ] = Σdt.17) (9.21) (9.24) Now.2 Poisson Factors Changing the Intensity Works Assume that the original factor is a Poisson Process dπ(t.2.16) (9. α + β) π and we see that the A and B representations remain the same under dψ = d˜ (t. In this case. 9.18) Thus.23) (9. α) + ηdt.2. in the case of multiple Brownian factors. DO THE FACTORS MATTER? and then by Ito’s lemma we have for c(S. α + β) where π α + β > 0. α) (9. α).22) (ct + µScS )dt + (c(σS) − c(S))d˜ (t. then P is also absence of arbitrage under a different set of factors dψ = d˜i (αi + βi ) π where αi + βi is the new intensity. α) we have dS dc = = µSdt + (σ − 1)Sdπ(t. (⋆) Arbitrage Invariance Principle for Poisson: If a set of prices P is absence of arbitrage under Poisson factors dπi (αi ). π Adding a Drift Doesn’t Work Again assume that the original factor is a Poisson Process dπ(t. The above results lead us to the following principle.25) (9. (⋆) Arbitrage Invariance Principle for Brownian Motion: If a set of prices P is absence of arbitrage under Brownian factors dz ∈ Rn with E[dzdz T ] = Σdt. α) → dψ = d˜ (t. α + β) π (9. α) (ct + µScS )dt + (c(σS) − c(S))dπ(t. changes in the correlations or the covariance structure is not allowed. α + β). α). α) + ηdt) π (ct + (µS + (σ − 1)ηS)cS )dt + (c(σS) − c(S))d˜ (t.19) (9. dc = = 1 z ct + µScS + σ 2 η 2 S 2 cSS dt + σScS (ηd˜) 2 1 ct + µScS + σ 2 η 2 S 2 cSS dt + σηScS (dψ) 2 91 (9. Now. Under dπ(t. Similarly.9. we have dS dc = = µSdt + (σ − 1)Sd˜ (t. t). α). α) (9. let’s consider changing the factor dπ(t. In this case. we have π dS dc = = µSdt + (σ − 1)Sdψ = µSdt + (σ − 1)S(d˜ (t. α) π (9. Therefore.26) and we see that there is no way to recover the original A and B representations under dψ. this substitution is not allowed.20) (ct + µScS )dt + (c(σS) − c(S))dπ(t. . α) we have dS dc = = µSdt + (σ − 1)Sdπ(t.

Then. we can replace dz → dψ = d˜ − λdt. Now.32) Equation (9.32) is called the risk neutral representation because all tradables have a drift equal to the market price of time. . First. the factors were replaced by new factors that contained the market prices of risk! Let’s formalize this notion of a risk neutral representation. (⋆) Risk Neutral Representation for Brownians: Let Prices P Changes d V = Factor Model A dt + B dz (9. under arbitrage invariant substitutions of the factors dz → dψ = d˜ − λdt.27) and the absence of arbitrage condition is A = Pλ0 + Bλ.3 Risk Neutral Representations The Brownian and Poisson factor invariance principles tell us that it is okay to alter or replace the factors in certain ways. by the Brownian factor invariance under changes to the drift. and absence of arbitrage prices under this representation will be the same as under the original representation using the actual Brownian factors. The fact that we can do this will ultimately lead us to the risk neutral pricing principle. let’s see what the risk neutral representations are. the z following tradable table will produce the same absence of arbitrage prices Prices P Changes d V = Factor Model Pλ0 dt + B d˜ z (9. regardless of how risky they really are. in this section we show that we can always replace the factors and put all tradables in what we will call a risk neutral representation.31) be a tradables table.3. z which leads to Prices Changes Factor Model (9. In fact.29) Now. But we are getting ahead of ourselves.30) = P Pλ0 dt + B d˜ d V z This is the risk neutral representation. THE ROAD TO RISK NEUTRALITY 9. The basic idea is that for any pricing problem. 9.1 Brownian Factors Prices P Changes d V = Factor Model A dt + B dz Consider the tradables table with Brownian factors dz (9. Note that to obtain this risk neutral representation. Why is this helpful? Because in some situations it is easier to price a derivative if we replace the factors by something different from the original factors.28) = P Pλ0 + Bλ dt + B dz d V Finally. we can substitute this into the tradables table to obtain Prices Changes Factor Model (9. we groups terms differently to obtain Prices P Changes d V = Pλ0 Factor Model dt + B (dz + λdt) (9.92 CHAPTER 9. we can replace the factors to create the risk neutral representation which leads to simplified pricing formulas. It states that we can find a replacement set of factors so that all tradables have a drift equal to the market price of time λ0 .

we can see that the drift of the value changes V for all tradables is equal to the market price of time λ0 . Thus. we subtract off the mean of the Poisson process so that the random factor has mean zero. if you are short a Poisson factor (B is negative). we can replace dπ(t. RISK NEUTRAL REPRESENTATIONS 93 9. let’s think about the market price of risk for a Poisson factor dπ. Prices P Changes d V = A Factor Model dt + B dπ(t. it is always good to hold a positive amount of a Poisson factor. α). we can substitute this into the tradables table to obtain Prices P Changes d V = Factor Model Pλ0 − Bλ′ dt + B dπ(t. On the other hand.40) Since the random factor term now has zero mean. which leads to Prices P Changes d V = Factor Model Pλ0 − Bλ′ dt + B d˜ (t. That is. α + β). Since a Poisson process either does nothing or jumps up by 1.35) (9. That is.34) Before proceeding.38) Now. being short a Poisson factor is adding real (downside) risk. . λ′ ) (here is where it is important that λ′ > 0. Now. All the risk is on the upside. but for our purposes.9. α) (9. Thus. This was the same as in Brownian case. so let’s define λ′ = −λ and rewrite the absence of arbitrage condition in terms of λ′ as A = = = Pλ0 + Bλ Pλ0 + B(−λ′ ) Pλ0 − Bλ′ (9. for Poisson processes. let’s just note that λ < 0 for a Poisson factor. λ′ ) π (9. I don’t like dealing with a negative quantity. α) (9. then you should be rewarded for taking on that risk. Let’s choose β = λ′ − α so that dψ = d˜ (t.3.36) (9. Prices P Changes d V = Pλ0 Factor Model dt + B (dπ(t.39) The final step is to compensate the Poisson process. One can show this in a much more rigorous fashion.33) and the absence of arbitrage condition is A = Pλ0 + Bλ (9. This is the risk neutral representation under Poisson factors! Note that in this case. we can replace the original Poisson factors by new Poisson factors with different intensities so that the drift of all tradables is the market price of time λ0 (don’t forget to subtract off the mean of the Poisson factors so that they have zero mean!). we would expect the market price of risk for a Poisson factor to be negative. by the Poisson factor invariance under changes to the intensity. the new intensity of the factors in the risk neutral representation is equal to (minus) the market price of risk! Let’s make this formal.2 Poisson Factors Consider the tradables table with Poisson factors dπ(t.3. and a negative market price of risk would reflect that. α) → dψ = d˜ (t. λ′ ) − λ′ dt) (9.37) where λ′ > 0. so π π that it can be an intensity!).

integration of both ˜ sides says that t ˜ P(0) = E e− 0 λ0 (s)ds P(t) . we can start with the risk neutral representation. α) (9. This risk neutral pricing principle applies in the Poisson case as well. so that V = P. Thus. From the risk neutral representaion equation (9. we have dP = λ0 Pdt + Bd˜ z which is telling us that the drift of P is λ0 when we use the factors based on d˜. λ′ ).46) since z is a Brownian motion. z Let’s assume that we are not dealing with a futures contract. Let’s see how it works for the Brownian case. α) → dψ = d˜ (t. this is a new pricing point of view that follows from the factor approach! The presentation has been a little abstract to this point. Then.42) is called the risk neutral representation because all tradables have a drift equal to the market price of time. This is because instead of starting with the real tradables table. (We also switched the d and the expectation. z (9. 9.45) λ0 (s)ds P =0 (9.48) ˜ where the expectation E(·) is taken under the risk neutral representation and λ0 is the market price of time. π (9. (⋆) The Risk Neutral Pricing Principle: Absence of arbitrage prices are given by the formula ˜ P(0) = E e− t 0 λ0 (s)ds P(t) (9. THE ROAD TO RISK NEUTRALITY (⋆) Risk Neutral Representation for Poissons: Let Prices P Changes d V = A Factor Model dt + B dπ(t.42) Equation (9. π the following tradable table will produce the same absence of arbitrage prices Prices P Changes d V = Pλ0 Factor Model dt + B (d˜ (t.32) we have dV = λ0 Pdt + Bd˜.47) We have arrived at risk neutral pricing.94 CHAPTER 9. The fact that the drift of all tradables is equal to the market price of time leads us to a convenient new pricing formula. λ′ ) − λ′ dt) . via Ito’s lemma one can verify that d e− Taking expectations of both sides gives ˜ d E e− t 0 t 0 (9. under arbitrage invariant substitutions of the factors dπ(t. z Now. (9.44) λ0 (s)ds P = e− t 0 λ0 (s)ds Bd˜.43) (9. so let’s see how it would work in practice.41) be a tradables table. .4 Pricing as an Expectation The risk neutral representations lead to a powerful risk neutral pricing formula. Thus.) Finally. regardless of how risky they really are.

56) where the e−r0 T was pulled out of the expectation because it is not random.53).1 How to Apply Risk Neutral Pricing Risk neutral pricing is applied using the following steps.54) Now. Performing this expectation leads to d1 d2 = = ln(S/K) + (r0 + 1 σ 2 )(T ) 2 √ σ T √ d1 − σ T (9. 9. then we know that c(S(T ). Via an arbitrage invariant substitution of the factors.53) (9. so the risk neutral pricing formula is ˜ c(S(0). etc. APPLICATIONS OF RISK NEUTRAL PRICING 95 9. let’s outline how it is applied. according to the risk neutral pricing principle.). 2 (9. z (9. we were able to obtain a pricing formula without resorting to partial differential equations! . T ) .2 Black-Scholes Let’s see how risk neutral pricing applies to the Black-Scholes setup. 1.49) (9. (9.51) Now. T ) = (S(T ) − K)+ . we have the same absence of arbitrage prices if we set all the drifts to the risk free rate (market price of time).57) (9. t) gives ˜ c(S(0).5.e. S(t) follows (9.59) c(S. 0) = SN (d1 ) − Ke−r0 T N (d2 ) which is the Black-Scholes formula! Thus.5. convert the tradables table to its risk neutral representation.50) (9. 0) = E e−r0 T c(S(T ).52) (9. Recall that the bond and stock follow dB dS dc = = = r0 Bdt µSdt + σSdz 1 (ct + µScS + σ 2 S 2 cSS )dt + σScS dz.58) (9.5. ˜ The expectation E(·) is taken under the risk neutral representation (i. 2.5 Applications of Risk Neutral Pricing Let’s see how the risk neutral pricing principle is used in a couple of familiar situations. Apply the Risk Neutral Pricing Formula to the derivative security that is being priced. if T is expiration. 9. applying the risk neutral pricing formula to the call option c(S. 0) = e−r0 T E (S(T ) − K)+ (9. But first.9. we have dB dS dc = = = r0 Bdt r0 Sdt + σSd˜ z r0 cdt + σScS d˜. Hence.55) But. That is it! Let’s clarify with some examples.

5.4 HJM Recall the HJM model of Section 7. we can apply the risk neutral pricing formula and the risk neutral representation is         0 r0 B B B  (dπ(λ′ ) − λ′ dt) .3 Poisson Model and the market price of time is λ0 = r0 while the market price of risk is λ1 = µ − r0 .4.2. t) = SΨ(x. ν) as was done in Section 6.65) y= (r0 − µ)kT k−1 (9. The tradables table is         0 r0 B B B  dπ(ν)  dt +   S  (k − 1)S µS d S  =  c(kS − ) − c(S − ) ct + µScS c c (9. y/k) where Ψ(α.60) For the risk neutral representation we use minus the market price of risk λ′ = 1 (9.4. so the risk neutral pricing formula is ˜ c(S(0). then we know that c(S(T ). y) − Ke−r0 (T ) Ψ(x. 0) = E e−r0 T c(S(T ).3.67) and the tradables are bonds that follow T dB(t|T ) = B(t|T )r(t|t) − B(t|T ) − B(t|T ) t T 1 µ(t|s)ds + B(t|T ) 2 σ(t|s)ds dz T t t T σ(t|s)σ(t|r)drds dt t . i! i=α ∞ (9. β) = e−β β i . 0) = e−r0 T E (S(T ) − K)+ . THE ROAD TO RISK NEUTRALITY 9. T ) . if T is expiration. Thus. I won’t compensate the original Poisson factor dπ(t.64) where the e−r0 T was pulled out of the expectation because it is not random.2. ˜ (9. (9.64) gives c(S.62) determines the expectation E(·).3. the underlying variables are given by the instantaneous forward rates dr(t|s) = µ(t|s)dt + σ(t|s)dz(t). k−1 r0 − µ k−1 Let’s try it for a Poisson model of Section 6. In this model.66) and x is the smallest non-negative integer greater than ln(K/S)−µ(T ) .1. To be consistent with the approach above in Section 9.5. (9. T ) = (S(T ) − K)+ .62) (9.1.61) Finally. ln(k) 9.  S  (k − 1)S d  S  =  r0 S  dt +  1 1 − − c(kS ) − c(S ) r0 c c c ˜ c(S(0). computing the expectation in (9.96 CHAPTER 9.63) But. In the risk neutral representation. (9.

z 2 ∂T ∂ ν(t|T ) ∂T (9.73) to compute the risk neutral drifts. Another way to get to this same result is to revisit the results of Section 7. by Ito’s lemma.74) ∂ ∂T 1 2 ν (t|T ) 2 = ν(t|T ) ∂ ν(t|T ) = σ(t|T ) ∂T T ∂ ln B(t|T ).2. Now. Once we have this.70) (9. let’s start over but with the risk neutral perspective in mind.71) (9.75) and note that in the risk neutral representation. the expectation is often computed by Monte Carlo.68) where d˜ is the risk neutral factor and r(t|t) = r0 (t) is the instantaneous short rate. pricing proceeds via expectations as in the risk neutral pricing formula. Since this is a single factor model. (9.3 this was extremely messy to deal with. one can compute the payoff value of a derivative. Thus. and compute the expectation of it. ∂T (9.73) These equations tell us that under the risk neutral representation. we can ask what z this implies about the instantaneous forward rates in the risk neutral world.22) that said: T µ(t|T ) − σ(t|T ) σ(t|s)ds = σ(t|T )λ1 t (9. we have dr(t|T ) = = If one lets σ(t|T ) = − then µ(t|T ) = where dr(t|T ) = µ(t|T )dt + σ(t|T )dz(t). .76) which is what we were looking for. the above equation becomes T µ(t|T ) = σ(t|T ) t σ(t|s)ds (9.69) ∂ ∂T ∂ ∂T 1 2 ∂ ν (t|T ) − r(t|t) dt − ν(t|T )d˜ z 2 ∂T 1 2 ∂ ν (t|T ) dt − ν(t|T )d˜. we would first estimate the volatilities of the instantaneous forward rates σ(t|T ) from market data.3 equation (7. This is the risk neutral priceing approach. then use (9. Well.73). we have a zero market price of risk λ1 = 0 (because all tradables earn the risk free rate).9. if we know the volatility of the instantaneous forward rates (σ(t|T )). Then. APPLICATIONS OF RISK NEUTRAL PRICING 97 If you recall from Section 7. That is. the risk neutral representation under Brownians tells us that we may write the tradables in the form dB(t|T ) = r(t|t)B(t|T )dt + ν(t|T )B(t|T )d˜ z (9. the relationship between the bonds B(t|T ) and the instantaneous forward rates is r(t|T ) = − Then. one simulates the risk neutral representation of the instantaneous forward rates. So. Let’s start with the tradables that are the bonds.72) σ(t|s)ds t (9. then we can compute what the drift terms must be by equation (9. Thus. In the HJM model. if we want to use the risk neutral representation.2.5.

is the subject of another little book. Recall that the LMM is similar to the HJM model. Recall from equation (7..5. Ti+1 ) and that are assumed to follow dR(t|T1 . We can use market data to estimate the bi terms (the volatility of the forward rates). But that.45).46) that the calibration relationship on the underlying Ri variables is   τ bj R i τ ai Ri − τ bi Ri j=1 (1+τ Rjj ) ρij τ bi−1 Ri−1 . That gave us the idea that perhaps we could change the factors (as long as we didn’t disturb the basic factor coefficient structure) and still arive at the same absense of arbitrage price. THE ROAD TO RISK NEUTRALITY 9. T2 )dz2 . my friends.70).98 CHAPTER 9. 9. The idea was that details of the factors do not seem to appear in the factor APT equations that we used throughout the book. Note that this is similar to what we had in the HJM risk neutral model.7. we write Ri = R(t|Ti . This is the basic notion of risk neutral pricing.7. there is quite a bit more that one can do when the full power and generality of the risk neutral approach is explored. T2 )dt + b1 R(t|T1 .7 Problems Problem 9. 9. By using a different set of factors (that still preserved the same absense of arbitrage prices) in many case we can simplify our calculations of the absense of arbitrage prices.77) (9. Ti+1 ) with dRi = ai Ri dt + bi Ri dzi .5 Libor Market Model The LMM model of Section 7. and then use equation (9.4 is also made quite simple by the use of risk neutrality..2 Verify equatin (9.81) a i = bi j=1 ρij (9. T2 ) = a1 R(t|T1 . This reduces the above equation to   τ bj R i τ ai Ri − τ bi Ri j=1 (1+τ Rjj ) ρij  (9.2.6 Summary The point of this chapter was to show that risk neutral pricing is a logical consequence of the factor approach to derivative pricing. Problem 9. = −λi−1 (1 + τ Ri−1 ) 1 + τ Ri (9. .78) (9.80) 0= 1 + τ Ri i τ a i R i − τ bi R i or finally j=1 i τ bj R j (1 + τ Rj ) τ bj R j (1 + τ Rj ) ρij = 0 (9.82) which is quite a bit simplier than what we started with.79) or by simplifying further Now.1 Verify equation (9. For notational simplicity. In fact. Pricing is then done by expectation. but deals with forward rates between times Ti and Ti+1 denoted by R(t|Ti .82) to obtain their drifts in the risk neutral representation. we can switch to the risk neutral representation by setting all the market prices of risk to zero λi−1 = 0.

7:127–154. 1993. Heston. 1977. 6(2):327–343. Black. The Arbitrage Theory of Capital Asset Pricing. Musiela.C.A.C. 1973. 59:341–360. Methods of Mathematical Economics. Ornstein. 2000. Williams. Rev. Gillespie. Diffusions. Vasicek.. Scholes. Journal of Financial Economics. [11] Robert C. Gatarek. Merton. Franklin. [7] J. 1997. Journal of Finance.Bibliography [1] F. Brace. 33(1):177– 186. [12] L. 3:167–179. Mathematical Finance. D. Bond Pricing and the Term Structure of Interest Rates: A New Methodology. Jarrow D. The market model of interest rate dynamics. Academic Press. 1976. Springer-Verlag. [2] F. Econometrica. J. Black and M. The pricing of commodity contracts. An Equilibrium Characterization of the Term Structure. Journal of Political Economy.C. The pricing of options and corporate liabilities. Cox and S. Ross.A. 5:177–188. 1976. [15] O.S. [14] G.E. 1930. [6] R. Markov Processes and Martingales: Volume 2. A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options. Econometrica.G. Morton. 1980. Rogers and D. Journal of Economic Theory. 1985. [5] J. The value of an option to exchange one asset for another. 81:637–659. and S. 3:145–166. [10] W. Margrabe. A. 1997. [9] S. 36:823–841. 53:385–467. Ross. Markov Processes: an introduction for physical scientists. and M. Cambridge. [3] A. Ingersoll. Cox. Phys. 1992. 1976. The Review of Financial Studies. 5:125–144. 1976. The valuation of options for alternative stochastic processes. [13] S. A theory of the term structure of inteest rates. Uhlenbeck and L. Ito Calculus. Journal of Financial Economics. 60(1):77–105. Journal of Financial Economics. Ross. 1978. L. Heath and A. 99 . [4] J. New York. [8] Daniel T. Option Pricing when the Underlying Stock Returns are Discontinuous. Journal of Financial Economics. On the theory of brownian motion.

95 Hedging. 31 Black-Scholes. 33 Market Price of Time. 77 Black-Scholes. 79. 25 Delta. 86 Incomplete. 55 Money Market Account. 7 intensity. 85 Derivative. 42 Dividends. 3 Poisson Processes Derivative Pricing. 69 Market Incomplete. 80 Implied Volatility. 7 Cox-Ingersoll-Ross.Index APT. 64 Dynamics. 84 Delta-Gamma. 41 Futures Derivative Pricing. 32 Poisson Process. 84 Delta Hedge. 64 Normal Random Variable. 1 geometric Brownian Motion Black-Scholes. 85 vega. 85 gamma. 3 Ito’s Lemma Obtaining Factor Models. 79. 85 rho. 81 Immunization. 85 delta. 42 Definition. 85 Taylor Expansion. 81 Hedging. 81 intensity. 35 Return Form. 54 Gaussian Random Variable. 80 Incomplete. 95 Formula. 49 Greeks. 32 Option European Call. 53 Poisson Random Variable. 3 Compound. 49. 63. 32 Price Form. 3 Calibration. 55 Libor-Market-Model. 44 Merton. 80 Delta. 25 Perpendicular Space. 32 Arbitrage Price Implication. 43 Factors. 43 Jump Diffusion Derivative Pricing. 55 Merton. 3 Price APT 100 . 66 Hedging. 46. 46 Market Price of Risk. 24. 1 Increment. 85 Immunization. 85 theta. 80 Brownian Motion. 1. 50 Factor Models Via Ito’s Lemma. 1 Null Space. 32 Relation to Range Space. 84 Delta-Gamma Hedge. 47 Compound Poisson Process. 33 Marketed Tradables. 35 Return Implication. 85 Heath-Jarrow-Morton. 43 Ornstein-Uhlenbeck.

32 Relation to Perp of Null Space. 64 Stochastic Process Compound Poisson Process. 7 Tradables. 32 Relative Pricing. 86 101 . 42 Marketed. 64 Volatility Implied. 92. 64 Vasicek. 92. 41 Vasicek. 44 Range Space.INDEX Application to Pricing. 94 Risk Neutral Representation. 44 Underlying Variables. 89 Pricing. 94 Short Rate. 44 Risk Neutral. 94 Risk Neutral Pricing Risk Neutral Representation. 24. 95 Principle. 44 Tradables Table. 64 Single Factor Models.

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